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Invest Like Young Buffett, Not the Current One

Invest Like Young Buffett, Not the Current One
(Paul Morigi/Getty Images)

By    |   Thursday, 10 May 2018 06:21 PM

Last weekend, nearly 40,000 people trekked to Omaha for the annual meeting of Berkshire Hathaway (BRK-A).

I wasn’t one of them. Having gone in 2010, I’ve found that once is enough. The opportunity to see and hear CEO Warren Buffett speak live in person is an opportunity every shareholder should experience. But in terms of understanding Buffett’s investment philosophy, his investment actions tell you a lot more than anything he says during the multi-hour Q&A session. (Full disclosure: I own some B shares. Not a lot.)

Buffett has warned for years that, as the company has grown, investments that “move the needle” will require larger and larger amounts of capital. That limits the company to larger acquisitions of entire companies, as well as larger positions in publicly-traded stocks.

To some extent, that may explain Buffett’s latest big buy in recent months, shares of consumer goods giant Apple (AAPL).

I’ll be honest—it’s a great company to own. And on a valuation basis, it looks a lot better than other companies out there. It’s a huge cash generator. But it’s already a huge company, the largest in the United States by market capitalization. That’s not necessarily good news.

Think about it this way: If you’re a passive market investor, like someone who uses index funds (like most 401k plans offer for instant diversification), you’re already an owner of Apple stock. In fact, since markets are weighted by market cap, a company like Apple is probably overrepresented in the average investor’s account, even if they’ve never directly bought a share.

In short, Apple is a great company, but it’s structurally a crowded trade. And Buffett is buying now, with shares near all-time highs. Furthermore, his rationale for buying is that the company is engaging in a massive share buyback program, so even if he never owns another share, his stake in the company will increase over time as shares are retired.

That’s the exact same rationale he was using back in 2011 when buying International Business Machines (IBM). It became a sizeable amount of the Berkshire portfolio, and despite the buybacks and dividends, it delivered poor returns. Buffett finally exited the position entirely earlier this year as a result.

While the Apple trade should go better—they have more cash flow, better products, and higher profit margins than IBM—there’s more to owning a company than whether or not they’re buying back shares. Apple has been on the ropes before, and it could only take a few new products that don’t resonate well with consumers to send shares (and revenue) tumbling.

A smart company doesn’t buy back shares when the market is paying all-time highs for them. They’re out there selling shares instead, to raise cash and prepare for a rainy day. The poster child for smart market moves is Teledyne. The old conglomerate went on an acquisition spree in the high-flying market of the 1960’s, financing its purchases with shares. When the stock market turned heavily bearish in the 1970’s, the company ended up tendering larger and larger amounts of shares, leading to a huge return in a decade-long flat market.

I’m not saying this investment will turn out terribly, but Buffett’s largest acquisitions of late have been in the kinds of businesses that a younger Buffett would ignore entirely.

The decision to buy the Burlington Northern Santa Fe railroad, for instance, involved a massive buy into a capital-intensive industry. While a booming economy can be great for rail traffic, rails and railcars need to be maintained and replaced periodically, and over a massive railroad, those costs run into the billions of dollars per year.

That’s a far cry from the decision to buy GEICO, or any of Berkshire’s other insurers. Insurers are highly regulated, of course, but they don’t need massive amounts of capital to maintain any physical property. It’s a function of cash coming in from policy holders and cash going out to policy holders. Good underwriting keeps cash going out to a minimum, and investing that cash in the meantime creates an interest-free loan known as “float.” That’s what young Buffett used to fuel a much smaller Berkshire. It’s the secret sauce that isn’t in some of these latest and large acquisitions.

Investors looking to be the next Buffett would be wise to look for opportunities to invest in companies that generate float. The insurance industry isn’t going anywhere, although technology like self-driving cars will likely substantially reduce accidents and subsequently lower insurance premiums. Items like home insurance, however, will hardly go away. A wealthier society has more risks to protect.

One such name is United Insurance Holdings Corp (UIHC). The company provides home insurance in multiple states. Trading at nine times forward earnings, it’s cheaper than both the market and Apple (AAPL).

While margins are currently slim, it’s been growing earnings at a rapid clip. And, much like Buffett’s ownership of Berkshire, management owns a massive stake in the company: over 52 percent per the most recent filing. With a modest 1.2 percent dividend yield and a market cap of around $800 million, it’s a smaller player in the insurance space—but one that could get bought up by a bigger player or taken private by management down the line.

There are even smaller companies out there, and if you’re looking to get the kind of huge returns that made Warren Buffett an exceptional investor, that’s the area you should be looking to invest in, not huge, widely-held companies (even if they look like a bargain).

And, of course, if you’re going to take the time to do a deep dive, invest accordingly. Concentrate your investments in your best ideas rather than diversify around (there’s always a tax-advantaged account like a 401k for that).

And stay away from companies that need a lot of the capital they generate just to stay in business. That’s fine when you’re a billionaire.

Andrew Packer is a Senior Financial Editor with Newsmax Media. He currently writes the Insider Hotline investment advisory, serves as investment director for the Financial Braintrust, and writes the monthly newsletter Crisis Point Investor.

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Stay away from companies that need a lot of the capital they generate just to stay in business. That’s fine when you’re a billionaire.
invest, young buffett, current, older, berkshire
Thursday, 10 May 2018 06:21 PM
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