Uncommon Financial Wisdom

I Make Some Changes May 10, 2013

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As a disciple of Warren Buffett, I make few changes to my investments. I find great companies and stick with them forever if I can. So, in fact, I haven’t made any changes to my fundamental positions since 2010. In 2009 and 2010 I was able to initiate a position in MMP and add to my HCN and Berkshire at good prices. Since then I have stood solid with my portfolio.

However, as readers note, I have had my HCN on watch because the dividends have not increased at a rate I am happy with. I have owned shares since the early 2000s and it has been a big winner for me since then. I still think it is a solid dividend choice, but the price has recently gotten extremely rich.

I always have a list of companies I follow. One that I have been looking to get into is Cisco Systems [CSCO]. The price of Cisco has fallen to less than fair value in my estimation, so I decided to liquidate 25% of my HCN and use those funds to initiate a position in CSCO. This is part of my dividend producing portfolio, so in reality it is just an exchange of part of my capital from HCN to CSCO.

Initially, the exchange will cost me some in dividends as when I sold the HCN, the dividend yield was 4.2%, while when I bought CSCO, the yield was 3.4%. However, I expect Cisco to increase dividends at twice the rate as HCN going forward.

Cisco System Inc. (CSCO) is the worldwide leader in the development of Internet Protocol-based networking products. The corporation has been generating solid profits over the last few years. It has also almost $50B in cash on the books. In 2011 it started paying dividends, which have almost tripled since then. It’s payout ratio is 25%. The P/E was less than 12 when I purchased. The earnings increased 27% last year and is expected to increase 21% this year.
All this indicates that it is a good value, with a strong ability to increase dividends in the double figures for the foreseeable future.

1. Solid Management
2. Good Products
3. History of profitability
4. Moat???? Not really.
5. Margin of Safety. Undervalued by perhaps 20% to 30%
6. Dividends? Short history of paying dividends. Small payout ratio. Large amount of cash on hand.
7. Free Cash Flow Margin: 22% [Indicates a cash cow]

So, in short it produces loads of cash, has a cash horde of $49B+, and produces good products and services with solid management.

A note on HCN. Had I given up on HCN and took all my profits, you could have surmised I felt a fundamental issue with it. But, because I only sold 25% of it, you can see I am still positive the stock, just paying close attention to the dividend increases.

The second move I made was to initiate ownership in a growth stock. This is a much riskier move and is somewhat out of character for me. But, I have had my eye out for technological changes that could have far reaching consequences and therefore create opportunity for outsized rewards. One such technology is 3D printing. 3D printing has been around for about 8 years now. However, it is just now starting to become readily adapted by a wide variety of user groups from manufacturing, architecture, medicine, design, etc. If you haven’t seen it, it is pretty cool.
You use CAD software to design your product, and then the 3D printer creates the model or product in an additive process of laying down successive layers of material. This differs from the traditional subtractive process of starting with a block of material and cutting it down. This process reduces waste and lowers cost because of its efficient use of material. Recently, the printers have come down in price to make it possible to have one on your desktop. Our local High School has one.

But the question I have been asking is to how to properly access this technology through an investment. The hardware companies are already richly valued with PEs in the 80s and 90s. I can’t get myself to pay that much for a company that is likely to see their profit margin drop tremendously, maybe even to 0 like regular printers over the next decade. Then it occurred to me that this is a classic “Gillette” situation. Gillette makes no money selling razors, but has a huge profit margin on the razor blades. Once you buy their razor you need to get replacement razors forever.

So my search brought me to the software companies that create the software used in all these applications. Hence Dessault Systemes [DASTY], one of two market leaders in 3D software. They are a large French company [$14B market cap], that is traded on the pink sheets in this country. There P/E is still a little rich at 34, but no where near as high as the hardware companies. It pays a small dividend [.8% yield]. It has been profitable for a long time now and has established itself in multiple software markets. Having said all that, I still think it is a risky move. I look to see it continue its double digit returns on earnings over the next 5-10 years, as Europe and Asia recover from the recession. If it does this, then I will be happy. It also appears to be increasing dividends substantially and I hope management continues on this vein. Of late, DASKY has been picking up small boutique software firms, consolidating their strengths. They create software for the so-called smart grid that is building around the world. And designer of wind turbines use their software to design the blades. They develop software for nuclear power plants that are big in China as well as hydro power construction software. Aerospace and automobile manufacturing has used this software for years, but there are many new markets emerging which are using the software; China, India, etc.

So even though my search was for 3D printing technology, I ended up with much more diverse company. A much more mature company. Yet, a company that is providing software for cutting edge technology in diverse fields all over the globe. I don’t expect it to move much over the next few years, but have high expectations for the positive movement in the decade.

Berkshire Annual Report 2012 March 4, 2013

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My largest holding remains Berkshire Hathaway. It sets the base for my investing portfolio, so I watch it very closely. Of course, I am always amused at how the media react to it.

As reported by the media, net income for the year was up 45% from the previous year. However, much of that was on increases in the derivative values. Income from operations was up 17% year to year. That is a healthy number. As I have mentioned over the last 4 years, Berkshire is a cash flowing machine. On top of that 17% increase is an increase in the float to $73 Billion. Float is money that can be used to invest today that will be paid out in the future for the insurance policies.

Buffet breaks out the business into 4 parts:

Insurance

For the 10th straight year there was an underwriting profit. This profit was $18.6 Billion pre-tax from $2.48B the year before. The aforementioned float was up to $73B. So in short, the insurance business at Berkshire is uniquely profitable and generating that free capital for expansion/investment of $73B. Really couldn’t ask for more.

Regulated Businesses

This is mainly BNSF and MidAmerican Energy. MidAmerican’s earnings rose to $1.32B from $1.2B, while the railroad [BNSF] earnings rose to $3.3B from $2.9B year on year. Solid increases for both.

Retail, Manufacturing, Service

Income rose in this category from $3.0B to $3.7B. They represent $22.6B of assets which earned 16.3% after tax. I will take that too.

Finance and Financial Products

This includes Clayton homes which services mortgages and several other companies. Net income rose to $848M from $774M.

Investments

This area gets the lion share of attention. But it has become a smaller part of the Berkshire picture over the last 20 years. The year end value was $86B up from $77B the year before. The much maligned derivatives have become worth more and more as the indexes they are based on have gone up. If they had to pay out at the end of last year [they actually won't be settling up until 2018-2024]. it would have cost Berkshire $3.9B, less than the $4.2B they received for them originally.

Buffett increased ownership in what he calls the big 4. Berkshire now owns 8.7% of Wells Fargo, 6% of IBM, 8.9% of Coca Cola [Through stock repurchases] and 13.7% of American Express. Buffett points out that Berkshire received $1.1B in dividends from these 4 companies, yet the share of income was $3.9B.

Total cash at the end of the year was $47B. $12B of that was recently invested in a partnership that will own Heinz Co.

Stock Price

Berkshire’s stock price rose 23% in 2012. It closed today at $152,995 another 9% increase since the first of the year. I will be keeping this stock and perhaps adding on to my ownership in the near future.