'The New Buffettology': Case Studies, Part 2
- By Robert Abbott
What was Warren Buffett (Trades, Portfolio) thinking when he made major investments in the Gannett Co. (GCI) and Freddie Mac? What process led him to conclude that these companies were good buys with robust long-term potential?
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In the lengthy chapter 19 of "The New Buffettology," authors Mary Buffett and David Clark offered four case studies to explain how he approached these buying opportunities. Two of the case studies, H&R Block (HRB) and La-Z-Boy (LZB), were covered in an earlier chapter; in this chapter, Gannett and Freddie Mac are covered.
The year was 1994 and the advertising industry was in a recession, which affected newspaper companies like Gannett. Buffett spent more than $335 million to buy a significant stake in the company, which published 190 newspapers at the time. The cost per share (split-adjusted) worked out to $24.45.
This is a simplified summary of the process he used to determine Gannett was his kind of company:
The company had a durable competitive advantage with a strong brand, USA Today for one, and many regional monopolies because it had the only paper in many towns and cities.
Buffett understood the newspaper business from the ground up because he had been a paper boy when young. More importantly, he had held a big stake in the Washington Post.
Gannett was conservatively financed: In 1994, its long-term debt was $767 million, while it brought in $465 million in earnings. So debt could have been eliminated in less than two years, if necessary.
Earnings were strong and growing. Between 1984 and 1994, they had grown at an average annual rate of 8.75%. The company achieved that rate, despite a minor recession in 1990 and 1991.
Gannett was sticking to its knitting when it came to capital allocation. Beyond newspapers, it bought only a few dozen radio and television stations.
It had been buying back shares, 42.4 million of them between 1984 and 1994.
Management had used retained earnings to grow its earnings per share. They grew from 70 cents in 1984 to $1.62 in 1994, an average 15.8% annual return.
Return on equity was above average, with an average annual return of 20.4% over those years.
Similarly, Gannett also posted high rates of return on its total capital (shareholder equity plus debt capital). An average of 15.3% over the decade.
Pricing of its products kept up with inflation. Since the company owned the only newspaper in many cities and was a strong competitor in others, it was able to increase both subscription and advertising prices as needed.
No large investments were needed to keep the plant and equipment up to date. Once newspapers, radio stations and television stations have their basic infrastructure in place, little new capital is needed.
The authors summed up this way, "Since Warren gets positive responses to the above key questions, he concludes that Gannett fits into his 'realm of confidence,' and that its earnings can be predicted with a fair degree of certainty. But a positive response to these questions does not invoke an automatic buy response."
The buy response will be triggered (or not) by the annual compounding rate of return. The metric is defined this way by Investopedia:
"The compound return is the rate of return, usually expressed as a percentage, that represents the cumulative effect that a series of gains or losses has on an original amount of capital over a period of time. Compound returns are usually expressed in annual terms, meaning that the percentage number that is reported represents the annualized rate at which capital has compounded over time... When expressed in annual terms, a compound return can be referred to as a Compound Annual Growth Rate (CAGR)."
In 1994, these were the key metrics for Gannett:
Earnings per share growth had averaged 8.75% per year.
It is assumed Gannett would continue to retain 60% of its earnings and pay out 40% in dividends.
These data allowed Buffett to project the company would earn $3.74 per share in 10 years, which was 2004. Further:
Assuming Gannett was trading, in 2004, at the lowest price-earnings ratio registered in the previous 10 years, 15 times earnings, the market price would be $56.10 ($3.74 x 15 = $56.10) before dividends.
In 10 years, the dividend pool would be $10.52. When added to the sum above, Buffett would have expected a share price of $66.62 per share, assuming the lowest price-earnings multiple.
Assuming instead that Gannett trades at the highest price-earnings ratio registered in the previous 10 years, 23 times earnings, the market price would be $86.02 before dividends, and $96.54 after dividends.
Buffett, then, can pay $24.45 for an investment expected to deliver something between $66.62 and $96.54 after 10 years. Then, by reversing the compounding, he would get to a range for the compounding rate of return: 10.55% to 14.72%
Buffett bought 13.7 million shares of Gannett at $24.45 in 1994. By 2002, the price per share had risen to $76 because earnings had been growing at an average of 16.2% per year, higher than the initially predicted 8.75%. As a result, if he had sold in 2002, he would have had a pretax, annual compounding return of 15.2%.
The fourth company in this chapter's case studies was Freddie Mac. Officially called the Federal Home Loan Mortgage Corp. (FMCC), it securitized and guaranteed mortgages. Securitization refers to the process of aggregating large numbers of residential mortgages, then selling the resultant packages to investors. "The New Buffettology" was written well before the housing collapse of 2008, in which Freddie Mac was a central player.
In this case, the authors looked at a major add-on purchase of Freddie Mac shares in 1992. We will summarize the annual compounding return calculations, using the same process as for Gannett.
Buffett and Berkshire Hathaway (BRK-A) (BRK-B) paid an average of $9.67 per share in 1992. The authors reported the projected price in 2002 would be expected to be in a range between $43.43 and $59.16 (using the historical low and high price-earnings ratios).
This would translate into an average annual compounding return of 16.2% to 19.8% pretax, no doubt satisfactory numbers for a careful stock picker such as Buffett.
Buffett and Berkshire sold their stock in 2000, stating that Freddie Mac's business model had changed and he did not like the new, riskier model. As it turned out, once again Buffett was a prescient investor, not because of any sixth sense, but because of his deep understanding of the company.
The authors wrote the price varied between $37 and $66 per share in 2000, while Buffett had paid an average of $9.67 per share in 1992. Leaving aside the details, they estimated his pretax annual compounding rate of return, before dividends, was somewhere between 18% and 27%.
About
Buffett and Clark are the authors of "The New Buffettology: The Proven Techniques for Investing Successfully in Changing Markets That Have Made Warren Bufett the World's Most Famous Investor." Buffett is a former daughter-in-law of the "Oracle of Omaha."
(This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
This article first appeared on GuruFocus.
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