In my last post, I discussed how Return on Shareholder’s Equity can be a useful metric in predicting the long term, sustainable rate of earnings and dividend growth.

I pointed out several companies in our portfolio which have ROE’s in the high teens to low twenty percent range, (or higher) which after adjusting for a 40-50% dividend payout ratio, should equate to a EPS growth rate of approximately 10-12% – higher than the market’s 8-9% estimated growth.

 But the analysis can and must go deeper at Berkshire:

 Any rationale investor seeking to own a business should start the process with 2 major questions in mind:

1)    “HOW does this company generate its profitability?

2)    “Is this profitability CONSISTENT AND SUSTAINABLE?”  (i.e. what are the threats to the cash flow?)

 Utilizing the DuPont formula, ROE can be broken down into its component parts and help answer those questions. 

 ROE = Operating Margins x Asset Intensity x Financial Leverage x Management of Taxes 

 The breakdown provides a road map for analysis for virtually any company in any industry:

 Operating Margins:

• How profitable is the core business?
  • What type of pricing strategy is the company following?
  • What kind of pricing power exists?
  • How does the company differentiate its products?
  • Can they charge more for this differentiation?
  • How economically sensitive is the company’s revenue?
• Asset Turnover:
  • How capital intensive is the business?
  • How much shareholder capital needs to be reinvested to maintain growth?
  • What level of fixed costs need to be covered to maintain break even status?
• Financial Leverage:
  • How does the use of debt magnify returns (or losses)?
  • What does management do with excess capital?
    • Buy back stock
    • Pay dividends
    • Reinvest back into the business
    • Make acquisitions
• Taxes Efficiency
  • How well does the company manage its tax obligations?

 Applying the Formula:

There is no “right” number for ROE or its components. It’s all business and industry dependent.  A company with stable revenue can handle more leverage (think consumer products, pharmaceuticals, or subscription based services) than a company with volatile earnings – (think energy, commodities or materials).

For example, operating margins for many steel companies at the peak of the cycle in 2008 rivaled that of many high margin consumer products companies. But a longer term look at DuPont analysis shows low to negative operating margins during many normal part of the cycle. Now our research indicates more steel capacity has come on line, demand has dropped, and margins are likely to fall – showing that ROE’s (and earnings growth) recently enjoyed by this sector are not sustainable.

In my next post, I’ll show specific examples of how we’ve used this type of analysis to make portfolio decisions.

Disclosure:

Berkshire equity portfolios and Berkshire employee accounts have long positions in the stocks and sectors mentioned in this post. 

The views expressed in this commentary reflect those of Berkshire Asset Management, LLC (Berkshire) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Berkshire disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading intent on behalf of any portfolio. The information contained herein has been prepared from sources believed to be reliable, but is not guaranteed by Berkshire as to its accuracy or completeness.

References to particular securities are intended only to explain the rationale for the portfolio manager’s action with respect to such securities. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities.

Investment Risk: All investments are subject to risk, including possible loss of principal. Because Berkshire Asset Management, LLC’s investment style expects to hold a concentrated portfolio of a limited number of securities, a decline in the value of these investments would cause the portfolio’s overall value to decline to a greater degree than a less concentrated portfolio. Our equity investment style may focus its investments in certain sectors or industries, thereby increasing the potential vulnerability to market volatility.

Banks, mortgage bondholders, and in our opinion the entire housing market just got a victory. The Senate defeated a bill that would allow judges to modify terms of mortgages in bankruptcy proceedings.

We have been of the opinion for some time that passage of this legislation would throw yet another wrench into tight credit markets and slow the eventual recovery in housing. Why? The end buyers of mortgage securities are one of the most important links in the securitization engine. Securitization (turning loans into bonds) allows mortgage credit to grow and flow freely around the globe. If judges were granted the ability to arbitrarily change contractual mortgage terms, balances, limit foreclosures etc, mortgage bond buyers will be less likely to purchase mortgage based debt in the future. Or, they will simply demand higher interest rates to compensate for the increased risk of a third party changing the terms of their bond during their ownership.  This of course will raise  mortgage costs,  and slow the flow of capital, and continue to depress home prices even further.

Since market lows set in July 2008, Berkshire equity portfolios have increased smartly and exceeded the return of the S&P 500 by a meaningful margin. Year to date results are also favorable vs. the market.    

There are two main drivers behind the results. The first is a fairly serious, yet incomplete correction in energy and materials related stocks. The price of crude oil has declined by over 20% since its high set in July. Gold is down and the dollar is enjoying a rally. Momentum, at least for now, looks like it has left the bullish oil trade. For example, despite threatening the movement 800,000 barrels of oil a day, Russia’s aggression towards Georgia didn’t cause much of a spike in the price of oil. Prices actually continued to decline. A few months ago, when the momentum was at a fever pitch, we suspect the price spike might have been greater surrounding a geopolitical event such as this.  

There is also evidence of true “demand destruction.” Higher prices have caused substitution and lower demand. U.S. drivers drove 9.88 billion less miles than they did last year*, a 3.7% drop. Commuting volumes in public transportation systems are way up. Employers are, in some cases, allowing 4 day work weeks to ease the costs of a five day commute. Companies are reworking their logistics and distribution systems to cut down on energy costs. Dealers can’t give away an SUV. Economic activity in Europe and China is slowing. Fueling the decline (or perhaps causing it) is a rebound in the dollar based on the premise the European Central Bank may have to lower interest rates, or is not in a position to raise them.  While slowing world wide demand is good for mollifying the news flow, keep in mind the US is by far and away the largest consumer of energy, chugging down 25% of daily oil volumes. China consumes about 8% of the total.  

The second cause for favorable results is a rebound in financial related stocks held in portfolios.  Our analysis and valuation framework strongly supported our opinion that bank stocks would likely bottom in mid-summer. It certainly looked like capitulation and panic selling the morning of July 15. For a few days in early July, it was not uncommon to see price swings of 25% in financial stocks in one day. Swings like this in (either direction) are indicators investors are not acting in any type of rational manner. It indicates they are merely reacting violently to whatever stinger headline or doomsayer happens to make it on CNBC. We used the volatility to our advantage by selectively adding to financials across portfolios.  We increased positions in Sovereign, and National City. We also added a new position in Merrill Lynch. Since then, many financials have rallied sharply and despite the large move, we still believe they are undervalued.  

^{*US Department of Transportation}

Important Disclosure: The views expressed in this commentary and www.berkshireobserver.net reflect those of Berkshire Asset Management, LLC (Berkshire) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Berkshire disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading intent on behalf of any portfolio. The information contained herein has been prepared from sources believed to be reliable, but is not guaranteed by Berkshire as to its accuracy or completeness. Past Performance is no guarantee of future results. Berkshire is an SEC registered investment advisor that manages accounts for individuals, institutions. A copy of our current ADV II is available upon request. References to particular securities are intended only to explain the rationale for the portfolio manager’s views and decisions with respect to such securities. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities. Investment Risk: All investments are subject to risk, including possible loss of principal. Because Berkshire Asset Management, LLC’s investment style expects to hold a concentrated portfolio of a limited number of securities, a decline in the value of these investments would cause the portfolio’s overall value to decline to a greater degree than a less concentrated portfolio. Our equity investment style may focus its investments in certain sectors or industries, thereby increasing the potential vulnerability to market volatility.