Mr Buffett: Is it plausible to try and copy-cat the world’s greatest Investor?!

 

Introduction

After watching the documentary ‘Warren Buffett: The world’s greatest money maker’ one gets an empowering sense they too could replicate the success of the ‘Oracle of Oklahoma’. This feeling came about due to the sheer simplicity in which he explains his investment strategy; in the documentary he states he follows the three criterion for all investments he makes:

·        Investment Philosophy

·        Security Selection

·        Psychology of Investing

 

I decided to investigate this in more detail to determine why, if it is so simple, others have struggled so much to replicate his success.

 

It is evident from the documentary that Buffett disagrees with the concept of debt financing; arguing “borrowed money has no place in the investor’s tool kit”. He highlights the dangers of highly leveraged firms, explaining that no-one can predict what is going to happen in markets. This is the first major lesson I learned:

 

1.      He doesn’t borrow to invest

 

Instead of amassing capital from bank loans he, rather intelligently, uses the float from the premiums his insurance business customers pay to invest. This is worth around $77 billion and carries an extremely simple but important advantage over traditional debt finance: It allows Berkshire to borrow at a cost averaging 2.2% (Worstall, 2013). The fact this figure is more than three percentage points below the average short-term financing cost of the American Government over the same period means Buffett is able to borrow at a rate which is below the market, therefore if his stocks make only market returns he will still outperform the market.

 

Even before Buffett acquired enough capital to implement this technique with his insurance business, he followed the same principal when making investments in small to medium sized businesses. This is the second lesson I derived from Mr Buffett:

 

2.      Use Profits to fund Operations

 

This is interlinked with the first lesson, but also carries extreme significance. He suggests that if he believes profit from one business could be put to better use, then this should be done. This point surprised me, as it reveals he does not agree with the idea that an optimum capital structure should be pursued. He is implying that trying to lower the WACC is risky because any slight changes to the WACC impact a manager’s decisions dramatically. This is the basis for arguments against Kraus and Litzenberger’s trade-off theory.

 

 

Although it may not be feasible for the vast majority of investors to imitate Buffett’s investing technique due to the enormous float generated from his insurance business, we can still learn some lessons from the ‘Oracle of Oklahoma’.

-          Use profits to fund operations

-          Sell off parts of the business if you think you could reinvest it better

 

Worstall, T. (2013). Explaining The Secret Of Warren Buffett's Success: Double Leverage. Forbes.com. Retrieved 15 April 2016, from http://www.forbes.com/sites/timworstall/2013/02/08/explaining-the-secret-of-warren-buffetts-success-double-leverage/#7d94b8767ba9

Dividend Policy: Are Global Miners BHP Billiton digging themselves into a deeper hole?!

This week BHP, the largest global mining company, announced they are to scrap their progressive dividend policy, comically only 6 months after their CEO Andrew Mackenzie made the contradicting statement “over my dead body sounds a little strong but it’s almost right”! In light of this news returns us once again to the age old question: Is dividend policy relevant?

An interesting point to begin with is the fact BHP vowed to maintain their progressive dividend policy by increasing the annual dividend by 2%, despite their share price and first half profits tumbling 92%! (Stringer, 2016). It is clear that the directors disagree with Modigliani and Miller’s (1961) dividend irrelevance theory. This is congruent with the popular view that dividend policy is important, as evidenced by the large amount of money involved and the attention that firms, security analysts, and investors give to dividends (Baker & Weigand, 2015). Personally I believe their decision to initially raise the dividend was to try raise investor confidence even though the market conditions are in a state of turmoil, with the price of a barrel of oil falling from 114.83p per barrel on april 01, 2011 to just 26.05p on feb 01, 2016 (Kumar, 2016). In a rather fitting quote, Andrew Lapping, deputy chief investment officer for South Africa-based fund Allan Gray Ltd., recently described miners promising ever-rising dividends as a “joke.” (Hoyle, 2016). It is likely BHP took Linter (2007) and Gordon’s (1959; 1962) “Bird-in-the-hand theory” into consideration when deciding to continue their progressive dividend policy. In their research, Linter and Gordon argue that dividends are preferable to capital gains due to uncertainty, and that investors would rather have the money now rather than leave it tied up in uncertain investments. This approach is likely to raise concerns amongst BHP’s investors.

Personally I agree with the dividend relevance theory, due to the fact Modigliani and Miller’s theory was based upon a number of assumptions, such as the reliance of perfect capital markets, no issue cost for securities and no tax. In reality, these factors have to be taken into consideration. Unfortunately we do not live in strong form markets, and there are transaction costs and hefty taxation implications.

 

 

 

 

 

 

 

Source: (Wsj, 2016).

BHP’s decision to scrap the policy has largely been influenced by the rest of the market’s attempts to improve their financial position by also cutting dividend.  All the main players have now cut their dividend, including Rio Tinto and Anglo-American. From this ordeal it has been made clear to myself the implications dividend policy has on the shareholder’s perceptions of the company. This dividend cut, which BHP were forced to do to try and savour their credit rating, even though this has been downgraded by Barclays and HSBC to “underweight,” has resulted in BHP’s stock falling significantly.

 

 

 

 

 

Source: (Cunningham, 2016). 

 

From this ordeal it has been made clear to myself the implications dividend policy has on the shareholder’s perceptions of the company. This dividend cut, which BHP were forced to do to try and savour their credit rating, even though this has been downgraded by Barclays and HSBC to “underweight,” has resulted in BHP’s stock falling significantly, as illustrated below.  This highlights how short term the market is, because now the short term returns have been cut a lot of shareholders have began to sell, hence the price drop.

 

Baker, H., & Weigand, R. (2015). Corporate dividend policy revisited. Managerial Finance, 41(2), 126-144. http://dx.doi.org/10.1108/mf-03-2014-0077

Cunningham, T. (2016). BHP Billiton tumbles amid fears of dividend cut. Telegraph.co.uk. Retrieved 14 March 2016, from http://www.telegraph.co.uk/finance/markets/marketreport/12095897/BHP-Billiton-tumbles-amid-fears-of-dividend-cut.html

Hoyle, R. (2016). BHP Billiton Slashes Its Dividend. WSJ. Retrieved 14 March 2016, from http://www.wsj.com/articles/bhp-billiton-slashes-its-dividend-1456177003

Kumar, D. (2016). Oil plumbs new lows below $27 as oversupply woes persist. Reuters. Retrieved 14 March 2016, from http://www.reuters.com/article/us-global-oil-idUSKCN0UY04U

Stringer, D. (2016). BHP Cuts Dividend for First Time in 15 Years on Profit Drop. Bloomberg.com. Retrieved 14 March 2016, from http://www.bloomberg.com/news/articles/2016-02-22/bhp-cuts-dividend-as-first-half-profits-fall-92-on-price-rout

The D Word: Is it Wise to Mess with Capital Structure?!

 

January, 2015 saw private equity house KKR receive the final instalment of their sale to Walgreen Co. which saw them triple their initial investment back in 2007. In this week’s blog I am going to examine how KKR maximised the benefit of capital structuring and reaped the rewards

Back in the 2007 debt fuelled buyout wave before the financial crisis, KKR bought Boots Alliances for $22billion: $19.55bn of that being paid for with debt with the remainder being cash (Carey, 2015). They brought the company out of the public domain by taking advantage of the extremely low interest rates at that time. By doing so this lowered their WACC. As KKRs return on invested capital is significantly higher than the WACC, they managed to make positive excess returns. The lower the WACC is, the higher the NPV of a project will be, meaning more returns will be generated. This principle disproves Modigliani and Miller’s “capital structure irrelevance theory” which argues that a company’s capital structure has no impact on the WACC. The main problem with M&M’s theory is that it doesn’t account for taxation: debt is advantageous over equity as debt has a tax advantage. It also assumes there are perfect capital markets, with perfect information available to all economic agents and no transaction costs. It also assumes there are no costs of financial distress and liquidation (Arnold, 2013).

As of today, KKR & Co LP's weighted average cost of capital is 6.12%. KKR & Co LP's return on invested capital is 30.14% (Bloomberg, 2015). KKR & Co LP generates higher returns on investment than it costs the company to raise the capital needed for that investment. It is earning excess returns. A firm that expects to continue generating positive excess returns on new investments in the future will see its value increase as growth increases

The basic principle here is as follows: load with debt; make a lot of net profit, then float again on stock market.  However, there’s a catch. This is all based upon the assumption that the cost of debt will remain the same. Warren Buffett, Berkshire Hathaway CEO warns against this kind of financing, suggesting you should not borrow to invest. Alternatively, private equity firms could use a float instead to fund their acquisitions. This would reduce the impact of any financial disasters as they wouldn’t be tied into any long term debt obligations and be forced into bankruptcy.

Personally, my views are consistent with the trade-off model (Kraus & Litzenberger, 1973) which suggests there is an optimum capital structure which could lower the WACC, up to a certain point. I think the benefits of debt finance outweigh the risks up to a certain point, after said point shareholders will become very cautious and this will have a negative impact on the share price of the firm. Debt finance is advantageous over equity as debt has a tax advantage.    

 

Arnold, G. (2013). Corporate financial management. London: Financial Times.

Carey, D. (2015). KKR Tripling Its Investment With Alliance-Walgreen Merger. Bloomberg.com. Retrieved 1 March 2016, from http://www.bloomberg.com/news/articles/2015-01-02/kkr-tripling-its-investment-with-alliance-walgreen-merger

Portfolio Theory: Should you put all your eggs in one basket?!

Portfolio theory has been the topic of debate for a number of years. First developed by Markowitz in 1952, the idea that investors can reduce risk by diversification and holding a portfolio of investments has been challenged by many investors; most notably Warren Buffett.

A prime example of Portfolio Theory being applied is in the pharmaceutical industry, which attract the question why has there been such a surge in mergers and acquisitions, with totals of $221 billion in the first half of 2015 (Wieczner, 2015).

 The giants in the pharmaceutical industry, such as Teva, Mylan and Pfizer, are diversifying their risk by buying smaller research focused companies. This is a much cheaper strategy and is far more suited to their high growth business model as they don’t have to invest years into researching and developing new drugs.                These companies believe that acquisitions are the only way to keep their revenues growing as fast as investors expect. The complexity of today’s breakthrough medicines mean that it is often cheaper for a company to acquire the next blockbuster drug than to develop it in-house. 

Personally I believe the pharmaceutical industry is an example of the application of portfolio theory being a success, as it is easy for a firm to just purchase a company to acquire new patents which can then be used to mass produce new drugs. When used in other contexts, for example as an investment technique, it is not always as efficient. It relies on past information to make future returns, which cannot give you an advantage as this information is and has already been available to the market. I’ll leave you with a thought; Warren Buffett claims you should “put all your eggs in one basket,” providing you are convinced it is the right investment. He did – in 1988 he bought $1billion worth of Coca-Cola stock, Buffett’s Berkshire Hathaway now owns… Wait for it… $18.3billion worth of Coca-Cola stock.

 

Wieczner, J. (2015). The real reasons for the pharma merger boom. Fortune. Retrieved 9 April 2016, from http://fortune.com/2015/07/28/why-pharma-mergers-are-booming/

Ft.com,. (2015). Pharma M&A: portfolio theory - FT.com. Financial Times. Retrieved 9 April 2016, from http://www.ft.com/cms/s/3/27db96f4-3474-11e5-b05b-b01debd57852.html?ftcamp=engage/capi/widget/client/openft/b2b#axzz3zrNwLRhE

Dividend Policy: Are Global Miners BHP Billiton digging themselves into a deeper hole?!

This week BHP, the largest global mining company, announced they are to scrap their progressive dividend policy, comically only 6 months after their CEO Andrew Mackenzie made the contradicting statement “over my dead body sounds a little strong but it’s almost right”! This news returns us once again to the age debate: Is dividend policy relevant?

An interesting point to begin with is the fact BHP vowed to maintain their progressive dividend policy by increasing the annual dividend by 2%, despite their share price and first half profits tumbling 92%! (Stringer, 2016). It is clear that the directors disagree with Modigliani and Miller’s (1961) dividend irrelevance theory. This is congruent with the popular view that dividend policy is important, as evidenced by the large amount of money involved and the attention that firms, security analysts, and investors give to dividends (Baker & Weigand, 2015). Personally I believe their decision to initially raise the dividend was to try raise investor confidence even though the market conditions are in a state of turmoil, with the price of a barrel of oil falling from 114.83p per barrel on april 01, 2011 to just 26.05p on feb 01, 2016 (Kumar, 2016). In a rather fitting quote, Andrew Lapping, deputy chief investment officer for South Africa-based fund Allan Gray Ltd., recently described miners promising ever-rising dividends as a “joke.” (Hoyle, 2016). It is likely BHP took Linter (2007) and Gordon’s (1959; 1962) “Bird-in-the-hand theory” into consideration when deciding to continue their progressive dividend policy. In their research, Linter and Gordon argue that dividends are preferable to capital gains due to uncertainty, and that investors would rather have the money now rather than leave it tied up in uncertain investments. This approach is likely to raise concerns amongst BHP’s investors.

Personally I agree with the dividend relevance theory, due to the fact Modigliani and Miller’s theory was based upon a number of assumptions, such as the reliance of perfect capital markets, no issue cost for securities and no tax. In reality, these factors have to be taken into consideration. Unfortunately we do not live in strong form markets, and there are transaction costs and hefty taxation implications.

 

 

 

 

 

 

 

Source: (Wsj, 2016).

BHP’s decision to scrap the policy has largely been influenced by the rest of the market’s attempts to improve their financial position by also cutting dividend.  All the main players have now cut their dividend, including Rio Tinto and Anglo-American. From this ordeal it has been made clear to myself the implications dividend policy has on the shareholder’s perceptions of the company. This dividend cut, which BHP were forced to do to try and savour their credit rating, even though this has been downgraded by Barclays and HSBC to “underweight,” has resulted in BHP’s stock falling significantly.

From this ordeal it has been made clear to myself the implications dividend policy has on the shareholder’s perceptions of the company. This dividend cut, which BHP were forced to do to try and savour their credit rating, even though this has been downgraded by Barclays and HSBC to “underweight,” has resulted in BHP’s stock falling significantly, as illustrated below.  This highlights how short term the market is, because now the short term returns have been cut a lot of shareholders have began to sell, hence the price drop.

 

 

 

 

 

 

 

Source: (Cunningham, 2016).  

Reference List

Baker, H., & Weigand, R. (2015). Corporate dividend policy revisited. Managerial Finance, 41(2), 126-144. http://dx.doi.org/10.1108/mf-03-2014-0077

Cunningham, T. (2016). BHP Billiton tumbles amid fears of dividend cut. Telegraph.co.uk. Retrieved 14 March 2016, from http://www.telegraph.co.uk/finance/markets/marketreport/12095897/BHP-Billiton-tumbles-amid-fears-of-dividend-cut.html

Hoyle, R. (2016). BHP Billiton Slashes Its Dividend. WSJ. Retrieved 14 March 2016, from http://www.wsj.com/articles/bhp-billiton-slashes-its-dividend-1456177003

Kumar, D. (2016). Oil plumbs new lows below $27 as oversupply woes persist. Reuters. Retrieved 14 March 2016, from http://www.reuters.com/article/us-global-oil-idUSKCN0UY04U

Stringer, D. (2016). BHP Cuts Dividend for First Time in 15 Years on Profit Drop. Bloomberg.com. Retrieved 14 March 2016, from http://www.bloomberg.com/news/articles/2016-02-22/bhp-cuts-dividend-as-first-half-profits-fall-92-on-price-rout