How Warren Buffett Saw Value in Berkshire Hathaway and Coca-Cola

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The worldwide melt-up is on track as June kicks off. Even gold is getting into the act. The yellow metal was 1.5% higher yesterday. And the average price for May was 5.5% higher than January’s average price. That average price, by the way, was a rather diabolical US$666. Dios mio!

On the topic of laggards vs. losers, how about we revisit the strategy of buying stocks whose market caps are below liquidation value? We reckon it’s worth a discussion. In bull markets, valuation metrics sometimes fall out of favour for the simple reason that they appear unnecessary.

For example, you don’t have to know how or why Bernoulli’s equation works to enjoy an aeroplane ride. As a passenger, all that matters to you is that the plane goes up, rather than plummeting to the ground. But as an investor, you shouldn’t leave all the heavy lifting in your stock selection to the fact that it’s a bull market.

Sometimes people simply forget how to value things. Take gold. A 20-year bear market in precious metals meant that very few investment institutions had experienced analysts around to find good gold companies once the market turned. A whole new crop of MBAs sporting handy discounted cash flow models find themselves utterly confused about how to value junior gold stocks. Experience counts. Inexperience costs.

So how do you find value? Yesterday, we mentioned that a good way to look for value in the stock market is to find shares whose market cap is below liquidation value. This is sound in principle. It is harder in practice. First, there simply aren’t many companies selling below liquidation value today. The stock market is well picked over and fully invested in.

The second problem with using only liquidation value as your buying signal is that sometimes there is a very good reason a stock is selling for less than what net tangible assets are worth. Even the great one, Warren Buffet, learned this the hard way. When Buffett first began investing in Berkshire Hathaway (NYSE: BRK.A) in 1962, it was a textile company selling for less than liquidation value. Graham and Dodd would have been proud.

But Buffett discovered what the market didn’t like about Berkshire. It was a terrible business. To remain competitive, it required constant capital. The constant investment in the company was not justified given the returns. The assets were eating up cash, not throwing it off. So Buffett reckoned the best use of the cash was to buy better assets that produced higher earnings, rather than eating up cash.

In other words, Buffett recognised it wasn’t enough to buy net tangible assets on sale. The assets had to be capable of one of two things, preferably both. The assets has to be capable of producing  a large increase in earnings without a large investment and/or the assets themselves had to have the potential to increase in value.

As an example, take Buffett’s 1988 investment in The Coca-Cola Company (NYSE:KO). Coke, as it’s better known, has current net tangible assets of US$11.7 billion. It has net income of US$5.24 billion in the most recent year. That gives Coke a 44% return on net tangible assets, which is a pretty nice return even by Australian equity market standards. Incidentally, Coke’s share price is up nearly 27% in the last twelve months.

Coke doesn’t have to invest huge new capital in assets to grow earnings. That’s what makes the stock so elegantly simple in terms of capital efficiency. You get a lot of earnings bang for your buck.

Dan Denning
The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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