The Curse Of Knowledge

The Curse of Knowledge

There are many difficult decisions to make when considering an investment in a particular business. Sometimes the more information we have the harder it is to make an accurate decision, we fall victim to what some may know as the “curse of knowledge.”

I recently read a few various experiments pertaining to the curse of knowledge and how impacts our judgment that I would like to share. First when we are solving a problem, there is an ability to use as many variables as we can identify, believing this will bring us a more accurate answer. Think about that the last investment you made and contrast that with how you catch a ball. Both include many different variables that we can identify such as the velocity of the ball, the trajectory of the ball, the mass of the ball, our speed, arm length, hand size, and I am sure you get the point.

Instead we use what some may know as a “gaze heuristic” to catch a ball, the same tactic dogs use to catch Frisbees and falcons use to target prey. When a ball comes in high, a player starts running and fixates his eye on the ball. The “gaze heuristic” is that you adjust your running speed and keep the angle of the gaze constant, which is in the middle of your view. If you do this than all you have to do now is finish, putting your mitt out to catch the ball or take it off the head.

As you can see you only pay attention to one variable, keeping the angle constant with the ball in the middle of your vision. This video is an example of a falcon using the same heuristic in action.

[Falcon Video]

The is a smart heuristic that we have used to adapt and survive over the years, as the brain structures our environment into a simple linear problem. Another experiment that I found fascinating was identifying cities in Germany and America.

First the Americans are asked to identify which German city has a higher population, Hanover or Bielefeld? When it came to the Americans, over 80% said it was Hanover, which is the correct answer but the Germans had a more difficult time because they had heard of both cities and began to try and recall facts. The same experiment was inverted with the two cities San Antonia and San Diego, this time the Germans had a 99% accuracy rating while only 66% of Americans answered correctly. This again is because of the “curse of knowledge”, as the people who are familiar with what is being asked tend to overthink the situation. The answer is San Diego.

Finally the last experiment I would like to share, relates to the stock market. There was four funds assembled, (1) Randomly Picked Stocks (2) Fidelity blue chip fund (3) Dow Jones (4) Least recognized stocks from a survey conducted of the S&P500 (5) Most recognized stocks in the survey conducted of the S&P500.

As you might have guessed already, or known before, is that the most recognized stocks that outperformed all other categories. So why does any of this matter?

Intrinsic Value, Margin of Safety and Don’t Lose Money

These are our smart heuristics, we focus on them relentlessly just like the falcon and his prey, but instead we are targeting large discounts. We don’t need to worry about a large portion of other things if we can get our estimates close to the actual outcome; when this occurs, we are in a position to future harvest our past sowing.

Everyone has heard Warren Buffett (TradesPortfolio) say “Rule number one: Don’t lose money, Rule number two: Follow Rule One.”

Have you thought of the true implications and math behind this statement? Most people have, I will spare you the repetition.

And another famous quote,

You only have to do a very few things right in your life so long as you don’t do too many things wrong.”

We need not focus on as many moving parts as we can identify but rather the important ones. The curse of knowledge does not take kindly to additional variables if they are not used correctly and it is usually best to use only a few of the most important variables when formulating a decision.

Advertisements

Standing In The Shoes Of The Oracle From Omaha: American Express

Most of us are familiar with the Salad Oil scandal of 1963 and the repercussions that followed. For the sake of the few that may not be aware of the Salad Oil scandal, I will give a brief background belowbefore trying to think like Warren Buffett.

Background of the Scandal

There was a fellow by the name of Anthony De Angelis who had started a company in 1955 to exploit the U.S Government’s Food and Peace program that aimed at selling surplus food to Europe for cheap. The company’s name was Allied Crude Vegetable Oil Refining Co. and De Angelis had been successful (for a scam artist). By 1962 he was a large player in the market and thought he could make more money by attempting to corner the market.

Cornering the market consisted of attempting to buy up all, or most of the current capacities supply (through futures), essentially creating an artificial demand, in turn driving prices of both current soybean oil inventories up (that he owned) and the future contracts (that he bought), for a large profit. De Angelis planned (and succeeded) to also use these inflated inventory values to further finance additional companies, through collateralized loans (against his current inventory).

American Express around the same time was entering into the warehousing business and had a specialized unit that made loans to businesses based on inventories. Essentially, De Angelis took these receipts from American Express to a bank or broker and had them discounted for cash. He soon realized this was a very easy way to make money and began falsifying inventory, using seawater.

American express was also duped when inspecting the warehouse. Elementary science teaches us oil is more viscous than water thus it sits on top of the water. When the inspectors checked the tanks their instruments only inspected the top of the tanks and some tanks also had pipes to transfer the oil between one another.

In the end things blew up, but not before De Angelis could secure loans from 51 businesses (ranging from P&G to Bank of America). After logistical mistakes and rumors of bribery, American Express was eventually tipped off. Over the weekend of November 15-18th, 1963 the salad oil scandal broke as American Express realized that Allied Crude did not have the reported 150 million in vegetable oil but instead had only 6 million. On November 19th, Allied Crude reported bankruptcy as the soybean futures crashed erasing the remaining value of the loans.

[Soybean futures below]

Unknown Warren Buffett (TradesPortfolio) Enters the Scene

The following Friday, Nov. 22, 1963 President Kennedy was assassinated and the market fell 3% but rebounded the following week. American Express stock was not so lucky, and was caught in a free fall that consisted of the shares falling from $65 a share in November 1963 to $37 a share in January 1964 or a 43% decline in less than 90 days. Buffett enters and begins buying shares of American Express between 1964 and 1966, eventually spending 13 million or 40% of the partnerships money. Buffett, by simply reading the 1963 and 1964 annual reports would have got a clear indication that American Express was actually not legally on the hook for the receipts but “morally obliged” to make good on the warehouse receipts.

[Dow Jones during Salad Oil Scandal and JFK Assassination]

In the 1964 annual report (link at the bottom) on pages 18-19 it is explained that the payment will not exceed 45 million and that certain insurance companies were actually subject to litigation to make good on their policies to pay for the losses, possibly further lowering the eventual payout. It is also explained and shown that this mishap did not material impact the business, as their main lines of business hit all time highs a year after the scandal broke.

[American Express Share Price 1959-1973, split adjusted]

Why Did Buffett Buy…? So Much? 

Now for the more exhilarating part, trying to understand what Buffett was thinking while he was buying and the valuation behind it. Lets estimate the average price of common shares for WB was $50. Combining that estimate with approximately 4.461 million outstanding shares (1964 annual report) we find an estimated market capitalization of 223 million.

Doing some other quick back-of-the-envelope calculations using the 1964 annual report we can compute the following:

  • Buffett paid roughly 17.79x, 1964 earnings and 2x, 1994 revenue.
  • Traveler Cheques and Travelers Letter of Credit had 10-year CAGR of 7%
  • Customer Deposits and Credit Balances had CAGR of 4.5%
  • 10-year revenue had CAGR of 10.89%
  • 10-year net income had CAGR of 8.76%
  • 2.8% dividend yield
  • 10x, 1964 EBIT and 16.9% operating margins

We get the general idea at $50 a share it was roughly fairly valued or a little undervalued depending on the valuation methodology (23% lower than where it was before the scandal broke). Why would Buffett put 40% of the partnerships money into something that was not trading at a large discount, at least a 50% discount to intrinsic value? American Express is the investment I presume, that Warren Buffett (TradesPortfolio) discovered the powers of the float, as he went on a “float” buying spree shortly after.

We see that American Express had 263.8 million in cash, 515.6 million in security investments at market value and a few other operational assets.

On the liabilities side we see two large numbers that stick out like a soar thumb, Travelers Cheques and Customer Deposits and Credit Balances of 525 million and 387.6 million respectively.

Now relating the idea back to the idea of floats and competitive advantages, if the brand of American Express is trust and loyalty, and that brand is not tainted, then we can assume the growth will continue in the float, bottom line and top line.

Lets assume 5.95% CAGR on the combined liabilities (using 0.58 and 0.48 weighting on growth outlined above). Now are the “liabilities” truly liabilities? Well what if the liabilities that come due are offset by the new liabilities that are taken on, what we will call using Peter to pay Paul. As long as there is no “run” on American Express over trust issues, we could assume that this is nearly 1 billion dollars of encumbered value or borrowed for free, which in turn we can invest in securities and earn a spread. American Express sold pieces of paper in exchange for actual money, sometimes the paper was not redeemed for long periods of time, sometimes never.

Reading the annual report we also find out that $45 million would be the maximum American Express would be willing to pay even though it was not legally obligated. We see that that can be easily covered with liquid assets.

Well when we look at it from that standpoint, what price would you pay for a perpetually growing zero-coupon bond? Close to nothing would be my bet, hence the free (or almost free) cost of an enduring float.

Well when that debt is eliminated from the equation, we end up with 983 million in shareholder equity or a 78% discount from intrinsic value (using a 223 million market cap).

Now lets assign some values to the outcome probabilities, over a course of 5 years.

5% chance of 80% capital impairment
40% chance of 100% gain
25% chance of 150% gain
20% chance of 200% gain
10% chance of 300% gain (98% of intrinsic value is achieved)

143% expected return or 28.6% annually for the next 5-years.

Things ended up better for Buffett who realized a gain of 154% over 3-4 years, buying at an estimated price of $50 a share and selling at an estimated share price of $126.5 turning an initial investment of 13 million into 33 million. This ended up being a 26-36% CAGR investment depending on n=3 or n=4.

Selling Too Early….. A Mistake Even the Best Make 

In the end Warren sold his investment too early and ended up buying it back at much higher prices missing out on a large portion of the returns and the steady stream of dividends to come. What he learned though from this experience likely became invaluable to him, as he learned how inefficient the market truly could be during unfavourable news, the power of a brand and enduring float, and the power of buying and holding great companies. After painfully selling his first investment early at 11 years old, cities service preferred stock soared and it happened again over the years with various other holdings, including American Express.

Warren came to the following realizations:

When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever.  We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds.

You should be fully aware of one attitude Charlie and I share that hurts our financial performance: We are very reluctant to sell sub-par businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations. Gin rummy managerial behavior (discard your least promising business at each turn) is not our style. We would rather have our overall results penalized a bit than engage in that kind of behavior.” 

He later bought American Express preferred stock in 1992 but sold out before the next reporting period. It was not until 1994 that Warren repurchased his shares of American Express, for the 3rd time in his life; he had the following to say.

“Our history with American Express goes way back and, in fact, fits the pattern of my pulling current investment decisions out of past associations. My American Express history includes a couple of episodes:

In the mid-1960’s, just after the stock was battered by the company’s infamous salad-oil scandal, we put about 40% of Buffett Partnership Ltd.’s capital into the stock – the largest investment the partnership had ever made.  I should add that this commitment gave us over 5% ownership in Amex at a cost of $13 million.

As I write this, we own just under 10%, which has cost us $1.36 billion.  (Amex earned $12.5 million in 1964 and $1.4 billion in 1994.) My history with Amex’s IDS unit, which today contributes about a third of the earnings of the company, goes back even further.

I first purchased stock in IDS in 1953 when it was growing rapidly and selling at a price-earnings ratio of only 3.  (There was a lot of low-hanging fruit in those days.)  I even produced a long report – do I ever write a short one? – on the company that I sold for $1 through an ad in the Wall Street Journal.

(Note: IDS was acquired by American Express in 1984 and spun into a stand-alone company, Ameriprise Financial. Ticker: AMP)

Obviously American Express and IDS (recently renamed American Express Financial Advisors) are far different operations today from what they were then.  Nevertheless, I find that a long-term familiarity with a company and its products is often helpful in evaluating it.”

The last part above is very crucial, as many of his investments embody his personal nostalgia. The next famous investment, which I will cover in my next post, is Walt Disney, after Warren met him personally. I highly recommend taking a look through the 1964 annual report posted below. You will find things have clearly changed, as the pages went from 32 in 1964 to 188 in 2012, or a 3.75% CAGR. Enjoy!

American Express 1964 Annual Report

 

The Perceived Value Of A Forecast

While the end of 2013 has come and gone, and the New Year has been ushered in, I have found my self once again pondering over the complexities involved in forecasting. I have been thinking more specifically about how those forecasts/predictions/estimates may be both beneficial and toxic to the perception of the interpreter. There have been more forecasts than I can count in the last few weeks, ranging from individual stocks picks, to the North American markets as a whole, followed by the macro picture in the emerging markets and China, U.S Treasuries, 3-D printing, gold, bitcoin, USDJPY, USDCAD and pretty much everything else under the sun.

This year I have (hopefully) learned more from the biases that manifest within predictions, from what I will call the “utility of predictions” and the self-cancelling/fulfilling (asymmetric) affects of the predictions (the premise of the article). The purpose will be much more philosophical than scientific, as much remains unknown regarding how predictions affect our decisions, or the “utility of the prediction” and how it can be quantified.

We will start off with a few failed predictions over the last quarter century that may have had an influence on economic outcomes, consisting of recessions, the 1981 Peru earthquake, farmers and weather.

Recession Predictions 

Most people have heard of the old saying that economists will have predicted nine of the last six recessions. Or maybe the saying, even a broken watch is right twice a day.

What those statements don’t say are the affects of having the wrong time for the other 1,438 minutes in the day or how market participants’ decisions will be affected by the other three recession forecasts.

“Charlie and I believe it’s a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of ‘experts,’ or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it.” –Warren Buffett (Trades,Portfolio)

Clearly economists do a terrible job (outlined above), and it is sometimes argued they actually add negative value. The question I am trying to answer here is how do economists (or other) predictors influence our actions and to what degree? I read an interesting study recently on weather and farmers’ decisions and found a few key things peculiar: how much they were influened and by what.

Weather and Farmers

The table above shows current and recent past conditions (CRPC), the short-term forecast (STF) and the long-term forecast (LTF). The numbers below are on a scale of 0 to 7, representing the utility of the forecast to farmers. Farming decisions were categorized into five groups corresponding to different stages of crop production: 1) agronomic decisions through planting (including choice of crop type, seed variety, tillage method, planting density, and date), 2) summer growing-season decisions (including applications of pesticides, herbicides, fertilizers, and irrigation), 3) harvest and postharvest decisions (including harvest date, autumn irrigation, and tillage), 4) crop insurance, purchased before the March 15 federal deadline of each year, and 5) marketing choices made throughout the year. The study characterized this outcome of utility by the following grouping of 10 descriptions,. i.e the value of each to the farmer:

  • Planting the best crop and variety; optimum spring tillage; best planting density and planting date.
  • Right amount of crop insurance.
  • Optimal amount of spraying, fertilizing, and water applied (used); best harvest date.
  • Maximizing crop revenue from marketing.
  • Lowest possible costs of production.
  • Reducing financial risk.
  • Sharing limited sources of irrigation water with others.
  • Reducing fertilizer and pesticides in runoff/ground water.
  • Sustaining rural communities.
  • Others (please specify).

As we can see from the study (the two pictures provided above), forecasting and past trends were clearly influencing the utility of the decision for the farmers from various sources, although some more than others (like the spouse or television and radio). There are also other various social norm weightings shown above; we can infer how influential a spouse and television/radio can be compared to others. (The scale is 0-49.)
The stronger the signal is perceived (or the more the forecaster is trusted to be accurate) the longer the signal will last. Attraction and repulsion laws will run there course and as more people are influenced by a particular forecast, the more likely they are to add to it, alter it or simply claim it as their own, causing an exponential function to the forecasts growth, or in a sense, self-fulfilling.

You may be asking, well, why does any of this matter? Why do I care? How can it benefit me? Well, think of how these simple everyday predictions are correlated with psychological sentiment (pessimism and optimism) the higher the emotional function, the more attraction or repulsion; the stronger the signal, the higher the utility of the forecasts. These are what I like to mentally visualize as the extremes of the investor emotional pendulum that is forever (albeit asymmetrically) swaying back and forth. If we want to exploit these extremes of emotion we must become students of our own (and others) pysche/emotion, conducting metacognitive thinking excersises.

We should ask and think probabilistically, do all the inputs create a signal or are they simply noise? Do the inputs affect my Bayesian prior in a material manner? Take the prediction by Bailey Willis of the 1981 earthquake in Peru that was supposed to be 9.9 in magnitude. This prediction ended up causing mass hysteria and real-estate prices to plummet simultaneously across the country although no serious earthquake came. These types of forecasts can have such strong affects of attraction that they become self-fulfilling, or so repulsive that they become self-defeating, hence the term “self-fulfilling prophesy.”

In the case of the earthquake, nature does not care about our perception or beliefs of an event, and nature produces no effect from the causation of our thoughts. Humans are quite different as we can/will influence others’ perceptions through our own narratives, predictions and beliefs. This of course is in the present or future tense and our confirmation bias, hindsight bias and narrative fallacy, all help to dilute the objective event as it passes into our own subjective perception. Mirror neurons further complicate what we believe, percieve and learn as we subconsciously/implicitly absorb others’ language, choices and actions.

I fee like I am rambling, and I will move to wrap up the conversation with a summary of a few main points.

  • Crowd wisdom may be flawed when the collective judgment is weighted inconsistently, giving certain variables higher or lower weights than others.
  • Forecasts can be self-fulfilling and self-defeating; what is the incentive of the forecast, is there any skin-in-the-game?
  • We all deliver some utility in what we believe and care to share about our beliefs; there isperceived value to a forecast
  • Hindsight bias, confirmation bias and narrative fallacy cloud our judgment about past events and how we perceive them.
  • We need to weigh forecasts probabilistically against our prior perceptions.
  • Do not make forecasts if you do not understand who you may be affecting and how their decisions may be impaired as a result; a forecast is not something that should be taken lightly.

Finally, we should not forget that 90% of all communication is non-verbal and our actions can speak profusely louder than our words. When a certain threshold of forecast-correlation becomes (implicitly) present, we will likely be affected. It takes much practice and experience to become a stoic contrarian.

Further Reading:

A great book I read recently covering forecasts and our inability/fallibility of predicting was, “The Signal and The Noise: Why So Many Predictions Fail – but Some Don’t” by Nate Silver.

Another great article from National Geographic I read recently and would recommend was about collective behavior in ants, bees and flocks of birds.

Swarm Intelligence is decentralized, self-organized Collective Behavior.

The Crocodile of the Moat: The Float (Part II)

The Crocodile of the Moat: The Float (Part II)

In the first part we discussed the value of floats in the form of deferred taxes, profitable insurance underwriting and the benefits of a hypothetical zero coupon perpetual bond. We will now examine the float provided by negative cash conversion cycles, negative working capital, and what I will generalize as “other” revolving credit, also known as trade payables and customer advances. All of the various components are intertwined together producing a cause-and-effect relationship, which we will examine below.

Cash Conversion Cycle and Working Capital

The cash conversion cycle is one of the accounting tools one may use to evaluate management’s effectiveness relative to competitors. The cash conversion cycle can be computed using the following balance sheet items:

  • Cash Conversion Cycle = DSO + DIO – DPO
  • Days Sales Outstanding (DSO) is defined as Average AR/Revenue per Day
  • Days Inventory Outstanding (DIO) is defined as Average Inventory/COGS per day
  • Days Payable Outstanding (DPO) is defined as Average Payables/COGS per day

Albeit (CCC) should not be viewed in isolation, meaning it must be viewed over multiple years andagainst competitors CCC to gauge a normalized and realistic industry trend.

So what does the CCC reveal?

The cash conversion cycle reveals the time it takes the business’s cash to convert to, or “flow” through inventory and accounts payable, then through sales and accounts receivable, and finally back to cash.

The lower the CCC, generally the better. Some companies (Amazon) are even able to manage a negative cycle, settling payables (sometimes as long as a month) after inventories are sold and payment is received. Negative and very low cash conversion cycles are not always feasible (to maintain) and it can be a signal of the competitive positioning the company has over its supply chain.

The competitors that are the best at managing cash, working capital, floats and human capital will likely be the ones with the largest moat in the particular industry or niche market. Jae Jun over at OSV has a great write up (I recommend you read it) further comparing a few shoe companies CCC and market returns. The CCC may be used in combination with other metrics as a key indicator of receivable cycles lengthening or inventory bloating, as well as the inverse and more beneficial scenario of inventories shrinking/payables lengthening.

The cash conversion cycle is best used to examine businesses that are dependent on cash flow produced from inventory turns, DSO and DPO. Contrast a retailer like Wal-Mart where CCC is very important with a REIT that owns no inventory and has no turns like Riocan (but has negative working capital) and is dependent on CAP rates and interest coverage.


Forbes also found an interesting correlation (depicted in the graphic above) between the four largest U.S retailer’s stock returns and the cash conversion cycle. 

The cash conversion cycle is essentially the working capital the business needs to operate, the more efficient and lower the cycle in days; the less working capital is needed. Some companies are able to extract more favorable financing terms than others due to economies of scale, industry characteristics, the individual business model, or cyclical supply/demand bursts.

In the info graphic above the typical working capital cycle is shown albeit the financing methods are missing and it assumes cash at particular points. Depending on the individual business model, competitive advantages and how the industry operates, receivables, payables and inventory may be rearranged. Take the example of Amazon. Amazon operates with a negative cash conversion cycle and negative working capital due to the economies of scale of their operations, the industry they operate within and the individual business plan.

Lets start with checking the cash received from sales versus the out lay of cash for the corresponding payables. Cash from sales are received immediately while the corresponding payable is settled at a later date. This produces a short-term float, as they are able to operate week-to-week with other people’s money. Second Amazon receives payment for Amazon Prime membership prior to providing the annual service (customer advance), again producing a float. Take a look at Amazons AR + Inventories versus AP.

1388937488210.png

And again with Wal-Mart, but not nearly as drastic.

1388894488591.png

We can see that the receivables and inventory are being easily financed by account payables, leaving a float left over in both cases. [Payables – (Inventory + AR)]

Other Revolving Credit: Customer Advances and Trade Payables 

As we can see with the example above, customer advances and trade credits are usually the result of a competitive position and economies of scale, as the bigger companies are able to “muscle” suppliers into more lenient terms.

For a quick review, a cost-less and enduring float is essentially a zero-coupon perpetual bong.

The closer the duration to infinity and the lower the cost is to zero the more the float resembles aperpetual zero coupon bond. Customer advances can be classified as gift cards, traveler cheques, deposits, and subscriptions or any other service a customer pays for before receiving, diminishing the accounts receivable cycle. Trade payables are credits extended from suppliers through (lengthening) the payable cycle.

What did Buffett have to say about these types of float?

If you get access to an enduring and free (or less-than-free) float — whether it comes from insurance underwriting, derivatives contracts, trading stamps, travelers’ cheques, stored value cards, deferred taxes or any other source — then assets financed with such a float will become“an unencumbered source of value” for your stockholders. This will happen because (1) the assets financed with such a float would still be valued on the basis of their expected future earning power; but (2) the true value of the liability represented by the float will be far lower than its carrying value, provided the float is both costless and long-enduring.”

Well we would have already likely known this to be somewhat true by analyzing other famous WB investments like American Express, Blue Chip Stamps or GEICO. Not all companies that have the ability to generate floats are large and dominant firms, but they do likely have a moat or else another company would encroach on this cost-less and enduring float. Blue Chip Stamps produced a valuable float that was recognized and utilized by Warren, as he explains below.

“An early precursor to frequent flyer miles in the 1950s and 1960s, trading stamps, such as Green Stamps, Blue and Gold, and Blue Chip, were handed out as a customer incentive by merchants. Retailers deposited money at Blue Chip in return for their stamps, then the money was used to operate the stamp company and to purchase the merchandise handed out when stamps were redeemed. Shoppers were given a certain number of stamps for each dollar spent in a store, which they pasted into books, then redeemed for prizes such as toddler toys, toasters, mixing howls, watches, and other items. Because it took time to accumulate enough stamps to redeem merchandise-and because some customers tossed the stamps in the back of a drawer, forgot them, and never did redeem them-the float built up.”

WB then used the [perpetual] float of Blue Chip Stamps to purchase another small company, See’s Candy. He also purchased American Express in 1964, producing a sizeable float through traveler cheques, which I will do a follow up case study about.

Are Floats and Moats Attached?

Free capital is a competitive advantage as it levers ROA and ROCE more efficiently than the alternatives of equity or debt financing, meaning float does not dilute shareholders to achieve this leverage.

“A good moat should produce good returns on invested capital. Anybody who says that they have a wonderful business that’s earning a lousy return on invested capital has got a different yardstick than we do.”

Float does just that, improves returns on invested capital as the denominator is lowered, because the business is able to operate (and sometimes invest) with other peoples money. Float does not dilute shareholders like equity or debt financing; it is the best capital structure choice for a business, all else equal.

It is quite possible that the float could also be used as a warning flag, prudently monitoring conversion cycles and the level of the float. If the float begins to decline in relation to operating assets, it is quite possible a competitive advantage may be eroding or a business cycle is coming to an end.

Finally, a key factor to acknowledge is that cyclical floats are hazardous and not enduringbecause at one point in the future the tides will turn (commodity businesses like steel production and auto manufactures). Lenient AP cycles will become more stringent and shorten, while AR cycles become more lenient (to off-set demand) and lengthens, causing a (who knows how long) needed increase in working capital. I do not want to put my business’s money up; I want to useother people’s money or……… a float.

The Crocodile Of The Moat: The Float (Part I)

 

Recently I have been enamored in fascination with how well Warren used floats over the course of his lifetime. I have been thinking about how various floats are linked to dominant firms and their economic moats. Looking for metrics like negative working capital, negative cash conversion cycles,derivatives, profitable insurance underwriting, deferred taxes and other payables that may or may not materialize and how they produce tactical leverage. I will be going through the various major and minor floats that I have been able to identify. The closer the float approaches a cost of zero and a duration that approaches infinity, the more it resembles a perpetual zero coupon bond. 

“Any company’s level of profitability is determined by three items:  (1) what its assets earn; (2) what its liabilities cost; and (3) its utilization of “leverage”— that is, the degree to which its assets are funded by liabilities rather than by equity.”

Warren used the words funded by liabilities rather than debt, and we should think of the float as a form of leverage, as it is other people’s money. Unlike debt, float is not financed by interest payments and unlike equity offerings; it will not dilute current shareholders. It is the best alternative source of financing. 

1. Deferred Taxes

Deferred taxes arise when the accounting books show different income than the tax books (allowance for debt, inventory, restructuring, depreciation charges and/or capital gains). Deferred taxes may also arise when marketable securities have market values that are higher than acquisition or book value. Warren Buffett long ago realized deferred taxes were an interest freeform of financing as depicted by his relentless harping of long-term holding periods (due to bothtax and compounding benefits) and Berkshire’s 2012 deferred taxes liabilities of 53.6 Billion.

Buffett illustrated very simply in his 1989 shareholder letter the benefits of deferring tax liabilities over a long period of time versus paying annual dues and the power of compounding the interest free U.S Treasury loan into his own equity.

“Imagine that Berkshire had only $1, which we put in a security that doubled by yearend and was then sold. Imagine further that we used the after-tax proceeds to repeat this process in each of the next 19 years, scoring a double each time. At the end of the 20 years, the 34% capital gains tax that we would have paid on the profits from each sale would have delivered about $13,000 to the government and we would be left with about $25,250. Not bad. If, however, we made a single fantastic investment that itself doubled 20 times during the 20 years, our dollar would grow to $1,048,576. Were we then to cash out, we would pay a 34% tax of roughly $356,500 and be left with about $692,000. The sole reason for this staggering difference in results would be the timing of tax payments.”

The Berkshire Hathaway owner’s manual also states the “funding sources” (insurance float and deferred taxes) lead to more assets than the equity capital would permit (assets + liabilities = equity) and has had no costs, essentially an unencumbered source of value. It should also be noted that the two make up just over 108 billion of Berkshires float and are clearly major financers of value creation.

“Berkshire has access to two low-cost, non-perilous sources of leverage that allow us to safely own far more assets than our equity capital alone would permit: deferred taxes and “float,” the funds of others that our insurance business holds because it receives premiums before needing to pay out losses.

Better yet, this funding to date has often been cost-free. Deferred tax liabilities bear no interest. And as long as we can break even in our insurance underwriting the cost of the float developed from that operation is zero. Neither item, of course, is equity; these are real liabilities. But they are liabilities without covenants or due dates attached to them. In effect, they give us the benefit of debt – an ability to have more assets working for us – but saddle us with none of its drawbacks.”

Charlie Munger also explained to Wesco shareholders in 2007 that the deferral of taxes is not working in perpetuity for shareholders thus the present value of the deferred taxes must be valued lower, much lower, than stated. Albeit how much lower is a question we cannot answer with conviction, due to the uncertainty of future taxation policy as well as the time that will pass until the taxes that will be recognized. 

“Wesco carries its investments at fair value, with unrealized appreciation, after income tax effect, included as a separate component of shareholders’ equity, and related deferred taxes included in income taxes payable, on its consolidated balance sheet. As indicated in the accompanying financial statements, Wesco’s net worth, as accountants compute it under their conventions, increased to $2.53 billion ($356 per Wesco share) at yearend 2007 from $2.40 billion ($337 per Wesco share) at yearend 2006. The main causes of the increase were net operating income after deduction of dividends paid to shareholders, and appreciation in fair value of investments.

The foregoing $356-per-share book value approximates liquidation value assuming that all Wesco’s non-security assets would liquidate, after taxes, at book value.

Of course, so long as Wesco does not liquidate, and does not sell any appreciated securities, it has, in effect, an interest-free “loan” from the government equal to its deferred income taxes of $322 million, subtracted in determining its net worth. This interest-free “loan” from the government is at this moment working for Wesco shareholders and amounted to about $45 per Wesco share at yearend 2007.

However, some day, parts of the interest-free “loan” may be removed as securities are sold. Therefore, Wesco’s shareholders have no perpetual advantage creating value for them of $45 per Wesco share. Instead, the present value of Wesco’s shareholders’ advantage must logically be much lower than $45 per Wesco share.” 

Essentially neither the (profitable) insurance float nor deferred taxes are worth their “book value” depicted on the balance sheet and would end up raising equity. Depending on the outcome, deferred tax assets (think NOL’s) or valuation allowances (essentially a subjective adjustment to DTAs) may also be created. For the sake of a beneficial float I would argue valuation allowances can be used to game earnings by some companies and the prior is an asset that should be discounted to (1+r) ^-n, (n being the estimated time the tax benefit will be received discounted at the cost of debt).

Deferred tax liabilities on the other hand (money you will have to pay eventually and our focus of the post) is not interest bearing, unencumbered and not paid in advance, so it may be utilized until an unspecified future date. This liability, in my opinion, is somewhere in between a non-existent liability and owners equity (call it no mans land) as the deferred tax will grow (and never be realized unless a sale is made) although the equity will grow at a quicker rate, as the cash is used to create more cash. The closer the float approaches a cost of zero and a duration that approaches infinity, the more it resembles a perpetual zero coupon bond. 

Well, what would we value a zero coupon bond that never matures?

I would say zero, or very close to it.

Benefit upfront and (maybe?) pay later or benefit later and pay now?

2. Profitable Insurance Underwriting

Profitable insurance underwriting is by no means an easy feat (over a long time period) and takes very talented risk/probability analysis. It is characterized by the combine ratio, the losses + expenses divided by the premiums received. As long as the premiums received are equal to the losses and expenses incurred, the float will be free. If the combined ratio is under 100 the holder of the float has been paid to hold the float. Amazingly, Berkshire grew their float from 39 million in 1970 to 73.12 billion in 2012 and in 37 of the 45 years (ending 2011) the industry as a whole had an underwriting loss. Ajit Jain has done a terrific job for Berkshire over the years at GEICO and he and GEICO continue to be a crown jewel of Berkshire. Buffett explained insurance in further detail in his 1995, 1997, and 2011 letter excerpts below.

“Since our float has cost us virtually nothing over the years, it has in effect served as equity. Of course, it differs from true equity in that it doesn’t belong to us. Nevertheless, let’s assume that instead of our having $3.4 billion of float at the end of 1994, we had replaced it with $3.4 billion of equity. Under this scenario, we would have owned no more assets than we did during 1995. We would, however, have had somewhat lower earnings because the cost of float was negative last year. That is, our float threw off profits. And, of course, to obtain the replacement equity, we would have needed to sell many new shares of Berkshire. The net result – more shares, equal assets and lower earnings – would have materially reduced the value of our stock. So you can understand why float wonderfully benefits a business – if it is obtained at a low cost.

Since 1967, when we entered the insurance business, our float has grown at an annual compounded rate of 21.7%. Better yet, it has cost us nothing, and in fact has made us money. Therein lies an accounting irony: Though our float is shown on our balance sheet as a liability, it has had a value to Berkshire greater than an equal amount of net worth would have had.”

So how does this attractive float affect intrinsic value calculations? Our float is deducted in full as a liability in calculating Berkshire’s book value, just as if we had to pay it out tomorrow and were unable to replenish it. But that’s an incorrect way to view float, which should instead be viewed as a revolving fund. If float is both costless and long-enduring, the true value of this liability is far lower than the accounting liability.”

Remember: The closer the float approaches zero-cost and has a duration that approaches infinity, the more it resembles a perpetual zero coupon bond and will be an unencumbered source of value.