Contango and backwardation refer to the shape of a single forward contract as we take snapshots across time
Contango is where the forward price of a commodity is higher than the expected spot price: investors/users are willing to pay more for a commodity at some point in the future than the actual expected price of the commodity
People may want to pay a premium to have the commodity in the future rather than paying the costs of storage and carry costs of buying the commodity today
If we assume that the spot price in the future is roughly similar to today’s spot price, the price of a single forward contract would fall through time towards the spot price as it moves towards maturity: see example below
When the market is in contango, it’s the commercial users of a commodity who are happy to lock in prices at the current level, while producers aren’t willing to lock in future production at the same level. So the commercial users of the commodity essentially pay speculators a premium to entice them to sell future production at the current price.
Contango is associated with oversupply, and rising levels of the commodity in storage
If we plot futures prices against contract maturities, we get a futures (or forward) curve. A curve associated with contango is a “normal” curve and slopes upwards.
An inverted market occurs can be associated with a market in backwardation, where the futures price for faraway deliveries is less than the spot price.
Normal backwardation (also called backwardation) is where the forward price of a commodity is lower than the expected spot price: investors/users are willing to pay less for a commodity at some point in the future than the actual expected price of the commodity
When a market like oil is in backwardation, it’s because producers want to lock in the current price for future production, while not so many commercial users want to lock in the current price. So producers sell their future production at a discount to the current price to entice speculators to buy their future production.
Backwardation is associated with undersupply, with falls in inventory levels
In encountering cross shareholdings between companies, namely the Washington H. Soul Pattison (ASX: SOL) and Brickworks (ASX: BKW) shareholder structure, how do you value each company?
Cross shareholdings inflate the reported market capitalisation of both companies above where they would be as standalone entities
The value attributable by external interests to two entities that have cross-shareholdings, A and B, can be performed with the following equations:
Let the two entities be A and B, with:
a_b = the proportion of A owned by B; and
b_a = the proportion of B owned by A
A = Assets of A excluding any cross-interests in B
B = Assets of B excluding any cross-interests in A
Then:
(1 – a_b) * Value_A + (1 – b_a) * Value_B = A + B
And:
Value_A = (A + b_a * B) / (1 – a_b * b_a)
Value_B = (B + a_b * A) / (1 – a_b * b_a)
In other words, the value attributable to the combined entity by external interests is the sum of the assets of the entities excluding the cross-interests.
If we want to value Soul Pattison, we have to:
Value its assets, excluding its interests in Brickworks
Value the assets of Brickworks, excluding its interests in Soul Pattison
Use the equation for Value_A above to calculate the value attributable by external interests to Soul Pattison
We then compare this to current market capitalisation of Soul Pattison to see whether Mr Market is being overly optimistic or pessimistic
Detailed references for the above equations are from the blog posts below:
Property & casualty industry had a combined ratio of 103 in 1976 vs 108.3 in 1975
In auto lines, the industry ratio improved from 113.5 to 107.4 but BRK improvement was better, moving from 115.4 to 98.7
Before long, the industry will fall behind on rates as temporary prosperity produces unwise competition.
When mistakes are made in the pricing of reinsurance, the effects continue for even longer than when similar mistakes are made in direct underwriting.
Auto lines seem highly vulnerable to pricing and regulatory problems produced by political and social factors beyond the control of individual companies
Insurance investments
On balance, we prefer a situation where our bond portfolio has a current market value less than carrying value, but more attractive rates are available on issues purchased with newly-generated funds
If business results for our portfolio companies continue to be excellent over a period of years, we are certain eventually to achieve good financial results for our stock holdings, regardless of wide year-to-year fluctuations in market values
We select equity holdings on a long term basis, weighing the same factors as would be involved in the purchase of 100% of an operating business
Favorable, long term economic characteristics
Competent and honest management
Purchase price attractive when measured against the yardstick of value to a private owner
An industry with which we are familiar and whose long term characteristics we feel competent to judge
Banking: Cost control is an important factor in the bank’s success
1977
Most companies define “record” earnings as a new high in earnings per share. There’s nothing particularly noteworthy about this as after all, a dormant savings account will produce steadily rising interest earnings each year because of compounding.
Except for special cases, a more appropriate measure of managerial economic performance is return on equity capital.
Special cases include companies with unusual debt-equity ratios, or those with important assets carried at unrealistic balance sheet values
Operating earnings on beginning equity was 19%, with beginning equity up 23% from the year previously
One of the lessons learned is the importance of being in a business where tailwinds prevail rather than headwinds
In Insurance:
Large rate increases occurred in 1976 to offset disastrous underwriting results of 1974-75
However, because insurance policies are written for 1 year periods, the impact of the repricing was only felt in 1977
Expect underwriting margins to decline due to high monetary and social inflation
Unusual managerial discipline will be required as markets loosen and rates become inadequate, as it runs counter to normal institutional behaviour to let the other fellow take away business – even at foolish prices
Insurance Companies
In general, insurance companies offer standardised policies which can be copied by anyone. Their only products are promises.
It’s not difficult to be licensed, and rates are an open book.
There are no important advantages from trademarks, patents, location, corporate longevity, raw material sources, etc., and no consumer differentiation to insulate from competition
There is no question that the nature of the insurance business magnifies the effect which individual managers have on company performance.
Insurance Investments
Just as it would be foolish to focus unduly on short-term prospects when acquiring an entire company, we think it equally unsound to become mesmerized by prospective near term earnings or recent trends in earnings when purchasing small pieces of a company
Our experience has been that pro-rata portions of truly outstanding businesses sometimes sell in the securities markets at very large discounts from the prices they would command in negotiated transactions involving entire companies.
For example: Capital Cities
To purchase directly the properties that Cap Cities owns would cost twice the cost of purchase via the stock market
Direct ownership would give the opportunity to manage operations but we would not be able to provide management equal to that now in place
Hence we can obtain a better result through non control than control
1978
We make no attempt to predict how security markets will behave; successfully forecasting short term stock price movements is something we think neither we nor anyone else can do
(The key is understanding) the underlying economic characteristics of these businesses
Textiles
Capital turnover (total sales / capital employed, or total assets) is low reflecting high investment levels in receivables and inventory compared to sales
Slow capital turnover, with low margins on sales leads to inadequate returns on capital
The textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage.
As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed.
Insurance
Worker’s compensation can cause large underwriting losses when rapid inflation interacts with changing social concepts
It is very easy to fool yourself regarding underwriting results in reinsurance. If major factors in the market don’t know their true costs, the competitive fall out hits all, even those with adequate cost knowledge.
Note our holdings in SAFECO: probably the best run large property and casualty insurance company in the US. Their underwriting abilities are superb, loss reserving conservative and their investment policies make great sense. Of course with a minor interest we do not have the right to direct or influence management polices – but why should we wish to do this?
While there may be less excitement and prestige in sitting back and letting others do the work, we think that’s all one loses (in passive participation).
An irresistible footnote: in 1971, pension fund managers invested a record 122% of net funds available in equities— at full prices they couldn’t buy enough of them. In 1974, after the bottom had fallen out, they committed a then record low of 21% to stocks.
A second footnote: in 1978 pension managers, a group that logically should maintain the longest of investment perspectives, put only 9% of net available funds into equities— breaking the record low figure set in 1974 and tied in 1977.
Our policy is to concentrate holdings. We try to avoid buying a little of this or that when we are only lukewarm about the business or its price. When we are convinced as to attractiveness, we believe in buying worthwhile amounts.
Companies should retain earnings where there are prospects for more profitable employment of capital. However, in industries with low capital requirements, or if management has a record of plowing capital into projects of low profitability, earnings should be paid out or used to repurchase shares.
Banking
The manager of an already high cost operation frequently is uncommonly resourceful in finding new ways to add to overhead
The manager of a tightly run operation usually continues to find additional methods to curtail costs, even when his costs are well below competitors
1979
We continue to feel that the ratio of operating earnings (before securities gains or losses) to shareholders’ equity with all securities valued at cost is the most appropriate way to measure any single year’s operating performance
The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.
Gain in book value since 1964 has been 20.5% compounded annually
We have achieved this while utilising a low amount of leverage (financial leverage: debt to equity; operating leverage: premium volume to capital funds of insurance business) without significant issuance or purchases of shares
Investor’s misery index: Inflation rate + % capital that must be paid by the owner to transfer into his pocket the annual earnings achieved by the business (eg. ordinary income tax on dividends and capital gains tax on retained earnings)
When this index exceeds the rate of return earned on equity in the business, the investor’s purchasing power (real capital) shrinks even though he consumes nothing at all
High inflation rates will not help us earn higher rates of return on equity
Turnarounds seldom turn: the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price.
Insurance
Much reinsurance business involves an exceptionally “long tail”, that allows catastrophic current loss experience to fester undetected for many years
Our insurance companies have not been a net purchaser of straight long-term bonds. Instead we have tried to concentrate in the straight bond area on shorter issues with sinking funds and on other issues that seemed undervalued.
We should have realised the futility of trying to be clever in an area where the tide was running heavily against us.
Our unwillingness to fix a price now for a pound of See’s candy or a yard of Berkshire cloth to be delivered in 2010 or 2020 makes us equally unwilling to buy bonds which set a price on money now for use in those years.
Overall, we opt for Polonius (slightly restated): “Neither a short-term borrower nor a long-term lender be.”
Your company is run on the principle of centralization of financial decisions at the top (the very top, it might be added), and rather extreme delegation of operating authority to a number of key managers at the individual company or business unit level.
This eliminates large layers of costs and dramatically speeds decision-making. Because everyone has a great deal to do, a very great deal gets done.
1980
Accounting Procedures for ownership interest follow one of the following
Business holdings > 50% owned: full consolidation of sales, expenses etc with a deduction for “minority interests”
Business holdings between 20-50%: proportional share of net income included as one-line entry in owner’s Income Statement
Business holdings < 20%: only proportional share of dividends paid out by companies held
Conventional accounting only allows less than half of earnings “iceberg” to appear above the surface due to ownership of interests < 20%
The value of retained earnings is determined by the use to which they are put and the subsequent level of earnings produced by that usage
Share repurchases: If a fine business is selling in the market for less than intrinsic value, what more certain or profitable utilisation of capital can there be than significant enlargement of the interests of all owners at that bargain price
When purchase prices are sensible, some long term market recognition of the accumulation of retained earnings almost certainly will occur
High rates of inflation create a tax on capital. Income tax by itself without inflation cannot turn a positive corporate return into a negative owner return. However, inflation rates can turn positive returns into negative returns for all owners.
The average Return On Equity of corporations is offset by the combination of the implicit tax on capital from inflation, and the explicit taxes on dividends and gains in value produced by retained earnings
For capital to be truly indexed (to inflation), return on equity must rise – earnings must increase in proportion to the price level increase without any need for the business to add to capital (including working capital employed)
The value of retained earnings will be determined by the skill with which they are put to use by management
When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.
GEICO: Managerial brilliance was required for it resuscitation. (However) the fundamental business advantage was still intact within the company, although submerged in a sea of financial and operating troubles.
GEICO was designed to be the low-cost operation in an enormous marketplace (auto insurance) competing against others whose marketing structures resisted adaptation
Extraordinary business franchises with a localised excisable cancer (needing a skilled surgeon) should be distinguished from the true “turnaround situation”
[Recommendation to read an excellent analysis of property-casualty insurance competitive dynamics – by Barbara Stewart of Chubb Corp. – Oct 1980 paper]
Thanks to nomeansum.com for posting this. The summary below is an outline of this video, which captures what most people need to know about macroeconomics.
3 factors behind the economy:
productivity growth
short term debt cycle
long term debt cycle
An economy is made up of transactions:
Economy is the sum of the transactions that make it up, buyer exchanging money/credit for goods, services, financial assets
Money + Credit = total spending (driving the economy)
Total spending / quantity = price
Economy = all transactions in all markets
The Central Govt – collects taxes and spends money
The Central Bank – controls amount of money & credit in the economy through interest rates and printing money
Credit is the most important part of the economy: biggest and most volatile
When borrowers promise to repay, and lenders believe them – credit is created. As soon as credit is created it turns into Debt
When a borrower receives credit, he increases his spending. Spending drives the economy: one person’s spending is another person’s income. When income rises, it makes people more creditworthy and hence more able to repay.
This is why we have cycles.
Productivity matters most in the long run but credit most in the short run (as productivity growth does not fluctuate much).
Debt is a driver of economic swings as it allows us to consume more than we produce when we get it, and forces us to consume less when we have to pay it back.
Because we borrow, we have cycles (rather than following productivity growth in the long term) due to human nature and the way credit works.
Borrowing is pulling spending forward – borrowing from your future self.
In the US, the total amount of credit is US$50 trillion, but the total amount of money is $US3 trillion
Credit is bad when it finances over-consumption that can’t be paid back. It’s good when it efficiently allocates resources and produces income so you can pay back the debt.
Short term debt cycle
Expansion: Spending increases – when spending is greater than quantity of goods, prices rise (inflation)
Inflation causes Central Banks to increase interest rates
Higher interest rates decreases amount of spending, and hence income
Economic activity decreases and creates deflation
Central Bank then lowers interest rates
Short term debt cycle lasts 5-8 years and lasts over and over again
Long term debt cycle
Debt burden: ratio of debt to income. So long as incomes continue to rise, this burden remains manageable.
As debt repayments increase, spending decreases, causing incomes to decrease
This leads to Deleveraging:
As incomes drop, borrowers get squeezed and become less creditworthy
Credit dries up. Borrowers are forced to sell assets – all at the same time.
As asset values drop, value of collateral drops
Less credit -> less spending -> less wealth -> less borrowing
In a deleveraging, borrower debt burdens have become too big to be relieved by lowering interest rates
What do you do about a deleveraging? 4 Options:
People, business and governments cut spending (austerity)
Debts reduced through defaults and restructuring
Wealth is redistributed from haves to have-nots
Banks print more money
However, austerity decreases spending and hence income, and increases debt burden
Depression occurs when people discover much of what they thought was wealth isn’t really there
Debt restructuring occurs when debt paid back is less or over a longer time frame. However, this causes spending and income to reduce so debt burden gets worse
Government budget deficits explode in a deleveraging because they spend more than they earn in taxes: taxes are reduced, payments to unemployed increase and stimulus is spent
So we end up with Central Banks being forced to print money as it’s inflationary rather than deflationary.
However, it can only buy financial assets with this.
Essentially Government Bonds are bought so that the Government can push money printed into the economy
Deleveraging can be beautiful
Debt declines relative to income
Real economic growth is positive
Inflation isn’t a problem
Achieved by having the right balance between inflationary and deflationary measures
Cutting spending, reducing debt and transferring wealth balanced with printing money
Printing money won’t increase inflation if balanced by falling credit
However, the key is not to print money so excessively that it causes unacceptable rates of inflation (as it’s so easy to do)
Summary Takeaway: Three rules of thumb
Don’t have debt rise faster than income (your debt burdens will eventually crush you)
Don’t have income rise faster than productivity (you’ll eventually become uncompetitive)
Do all that you can to raise your productivity (because in the long run that’s what matters most)
Then we compute the consequences of the guess to see what it would imply
Then we compare the computation with experiment/experience/nature/observation
If it disagrees with experiment, it’s wrong.
To be scientific, one can only specify what is likely and what is unlikely. All we can do is guess the most likely explanation, but if it doesn’t work, we have to try the other one.
You can disprove any definite theory
Theory can never be proved right – be can never be right, we can only be sure we’re wrong
Note that you can never prove a vague theory wrong – having a vague theory, it’s possible to get either result you want
Illinois National Bank: While maintaining a position of above average liquidity, net operating earnings before security gains came to well over 2% of average deposits
Deposit growth in consumer savings will have attendant high costs
1971
1. Insurance
Management of insurance companies is very important: management have to behave in a rational way
The insurer should not be focused on achieving volume, but should be focused on underwriting profit
Ideally, the insurer should experience volume increases when standard markets become tight, and volume decreases when underwriting profitability is high in the industry, and competitors are cutting rates (and increasing their exposure)
2. Banking
Illinois National earned well over 2% after tax on average deposits while:
Not using borrowed funds except for very occasional reserve balancing transactions
Maintaining a liquidity position far above average
Recording loan losses far below average
Utilising a mix of over 50% time deposits with all consumer savings accounts receiving maximum permitted interest rates throughout the year (mix of deposits has moved more than the industry average away from demand money to more expensive time money)
The above reflects a superb management job
3. Key metrics
Focus on return on capital (long term debt + equity) and return on equity
ROC and ROE calculated based on beginning balances
1972
Textile operation profitability is determined by the general level of profitability of the industry, and relative position within the industry
Insurance prospects for the next 5 years would have been better if profits had not risen so dramatically this year
We will continue to base our (underwriting) rates on long term expectations rather than short term hopes
Underwriting profitability is the yardstick of success though expense ratios may be high in the development stage
Illinois Bank achieved after tax earnings of 2.2% on average deposits, even with 1971’s moderating factors, and even with a policy that produces a net charge-off ratio in the last two years of about 5% of that of the average commercial bank.
Net charge-off: percentage representing the amount of debt that a company believes it will never collect, compared to average receivables. Debt that is unlikely to be recovered is written off as gross charge-off, with any money collected on this debt subtracted from this to calculate the net charge-off.
1973
Management’s objective is to achieve a return on capital over the long term which averages somewhat higher than that of American industry generally—while utilizing sound accounting and debt policies
Illinois Bank achieved after tax earnings of 2.1% after taxes, even with 60% deposits being time deposits
Merger with Diversified Retailing Company, which also owned Berkshire Hathaway shares, as well as Blue Chip (which owned See’s Candy Shops and part of Wesco)
1974
Prior unusual insurance profitability attracted unintelligent competition and inadequate rates. Many insurance organisations have been guilty of underreserving of losses, producing faulty information about the true cost of the product being sold
Where rates do not increase (due to competition) but inflation grinding at repair services (to humans and property), profit margins will reduce
“At some point in the cycle, after major insurance companies have had their fill of red ink, history indicates that we will experience an inflow of business at compensatory rates.”
In this year both bond and equity market values had net unrealised losses: bond market value movements are not considered to be of great importance as long as adequate liquidity is maintained (bonds will not have to be sold at times other than our choice)
1975
Economic inflation produced loss costs beyond premiums established in a different cost environment
“Social” inflation caused liabilities beyond limits contemplated when rates were established: eg. propensity to sue, possibility of collecting massive awards for events not previously considered statistically significant
The measurement of success will continue to be the achievement of a low combined ratio: ie. (incurred losses + expenses ) / earned premium; Ratio < 100% indicates underwriting profit
Our equity investments are heavily concentrated in a few companies which are selected based on favorable economic characteristics, competent and honest management, and a purchase price attractive when measured against the yardstick of value to a private owner.
In 1975 the thirty largest banks in the US earned an average of 0.5% on total assets. Illinois National earned 4x that much.
These largest banks carried down 7% of operating revenues to net income but Illinois National carried down 27%.
Overall equity per share has compounded at an annual rate slightly over 15% since 1965
What constitutes a good bank, or insurance company? The notes below will continuously be updated.
Notes:
1. Insurance
Management of insurance companies is very important: management have to behave in a rational way
The insurer should not be focused on achieving volume, but should be focused on underwriting profit: Stick with business that you understand and want, without consideration of impact on volume
Ideally, the insurer should experience volume increases when standard markets become tight, and volume decreases when underwriting profitability is high in the industry, and competitors are cutting rates (and increasing their exposure)
The measurement of success (is) the achievement of a low combined ratio: ie. (incurred losses + expenses ) / earned premium; Ratio < 100% indicates underwriting profit
Worker’s compensation can cause large underwriting losses when rapid inflation interacts with changing social concepts
It is very easy to fool yourself regarding underwriting results in reinsurance. If major factors in the market don’t know their true costs, the competitive fall out hits all, even those with adequate cost knowledge.
Insurance is highly cyclical: you have to look at the overall industry combined ratio to see where in the cycle you are, and compare rates movement to inflation. Margins will remain steady only if rates rise faster than costs.
You want to buy an insurer with great underwriting abilities, conservative loss reserving and investment policies that make great sense.
An insurer with high operating leverage has high premium volume to capital funds
Much reinsurance business involves an exceptionally “long tail”, that allows catastrophic current loss experience to fester undetected for many years
2. Banking
Illinois National earned well over 2% after tax on average deposits while:
Not using borrowed funds except for very occasional reserve balancing transactions
Maintaining a liquidity position far above average
Recording loan losses far below average
Utilising a mix of over 50% time deposits with all consumer savings accounts receiving maximum permitted interest rates throughout the year (mix of deposits has moved more than the industry average away from demand money to more expensive time money)
Having a policy that produces a net charge-off ratio in the last two years of about 5% of that of the average commercial bank.
You have to have models in your head from multiple disciplines:
Mathematics: Compound interest
Permutations and combinations (probability and decision trees)
Accounting and its limitations
5 Ws: Tell who was going to do what, where, when and why
Understand statistics: Gaussian curve
Engineering idea of a backup system, and breakpoints
Physics: Critical mass
Psychology of misjudgement
Ecosystem: narrow specialisation and niches
Microeconomics: advantages of scale
eg. cost reductions along the experience curve
eg. size of company and use of TV advertising when it first arrived, as the most effective marketing type
Social proof
Cascade towards overwhelming dominance of one firm (winner takes all): eg. newspapers
Disadvantages of scale: competitors move towards a narrower specialisation (scaling down and intensifying)
Many markets get down to two or three big competitors or five or six. And in some of those markets, nobody makes any money to speak of (eg. airlines). But in others, everybody does very well (eg. cereals)
Where do the benefits of cost reductions / efficiencies go? To the guy that buys the new equipment, or to the customer?
Competitive destruction: surfing the way of a new business
Identify your circle of competence: what are your inadequacies
Cancer surgery formula: Look at a business mess and figure out if there’s anything sound left that can live on its own if they cut away everything else. If you can find anything sound, just cut away everything else. Of course, if that doesn’t work, liquidate the business. Can you cut out the folly and go back to the wonderful business?
Two track analysis
Rationality: evaluate the real interests (what are the factors that really govern the interests involved, rationally considered), real probabilities
Evaluate the psychological factors that cause subconscious conclusions, many of which are wrong
Common stocks
Like a pari-mutuel system at the racetrack: a pari-mutuel system is a market. Everybody goes there and bets and the
odds change based on what’s bet
Bet only when you have a mispriced bet available, bet very seldom but bet big when you have the odds
Understand the concept of “Mr Market”
Most of the bulk of the billions in BRK have come from the great businesses. Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns.
Find great businesses when they’re small, run by a wonderful manager (but bet on business momentum, not the brilliance of the manager)
Watch for the effect of tax deferral on returns but don’t be overly motivated by tax considerations
There are huge advantages for an individual to get into a position where you make a few great investments and just sit back and wait
Only 25 of the 1000 companies averaged over 20% ROE and had no single year lower than 15% ROE
Only 6 of the 1000 companies averaged over 30% ROE over the previous decade (1977-1986)
These 25 “business superstars were also stock market superstars” as 24 out of 25 outperformed the S&P 500 during the 1977-1986 period.
Most of these companies sell non-sexy products or services in much the same manner as they did 10 years ago (though in larger quantities, or at higher prices, or both)
“The record of these 25 companies confirms that making the most of an already strong business franchise, or concentrating on a single winning business theme, is what usually produces exceptional economics“
Look for high quality operating businesses with simple, predictable business models that produce high returns on capital at 10 times normalised earnings that can be reinvested at similar rates of return (future growth opportunities).
If we use Wells Fargo as an example, over 10-15 year periods or longer, paying 2 times book for a business like WFC will nearly always work out better than paying 0.5 times book for a low earning community bank.
Just determine the current earnings yield and make sure you have an understanding about the future prospects of the business to determine if you think those earnings will be higher or lower over time.
When a business person thinks about risk, they think about the competitive position of the business, the competition, the future prospects, and the management of the business
The key is incremental ROIC and reinvestment rate – eg. if a business produces 20% incremental returns on capital that can reinvest 50% of earnings at this rate (capital allocation) will grow intrinsic value by 10% annually
(1) Check how much of earnings is paid as dividends and assume balance retained is reinvested
or (2) For stable businesses, look at balance sheet 10 years previously, compare capital to today’s and increase in capital to increase in earnings
Charlie Munger: “Over time, the owner of a business will likely see investment results that (over very long periods of time) begin to approximate the internal returns that the business produces.”
Taking this approach eliminates the need to be right about timing and to constantly produce good investment ideas
Slowly and steadily buy cheap stocks of average quality and sell them as they appreciate to fair value, repeating the process over time as you cycle through endless new opportunities. Businesses here are bought to be sold to someone else at a higher price.
A business that is shrinking its intrinsic value means that time is your enemy–you must sell as soon as you can because the longer you hold it, the lower the intrinsic value becomes.
3. Take advantage of special situations
Spinoffs, restructurings, bankruptcy, sum of the parts
4. Buy a statistically cheap group of stocks
Graham’s Net-nets
Approach also taken with authors of “Quantitative Value”, and Joel Greenblatt’s Magic Formula
In his book “Value Investing”, Bruce Greenwald from Columbia University explains the difference between Carsales and an asset heavy business like RNY as follows:
For a business with no competitive advantage and free entry, then its intrinsic value should approximate the replacement value of its assets (less debt). The replacement value of the assets includes any costs associated with building up marketing, R&D, sales teams etc, so its not just “hard assets”. The reason is simply that anyone can replicate the business (and its value) by spending to create the assets it holds.
In contrast, for a business with a sustainable competitive advantage, then its intrinsic value should be based on its earnings power and should exceed its replacement value of assets. In this case, even if a competitor went out and replicated the assets, that competitor would not be as profitable or worth as much because it can’t replicate the competitive advantage. This would be the case for both Carsales and Perpetual.
Valuation Methods:
Discounted Cash Flow
Need to project into the future and estimate a growth rate so can only use for stable businesses
Does not work well for young, growth or cyclical businesses
Reverse DCF
Use to figure out if you’re being too aggressive with your valuation
365 Annual Reports 
