Friday, May 15, 2015

Market Valuation (Scatter Plot)

So, Buffett's response (at the 2015 annual meeting) to questions regarding the valuation of the stock market was interesting.  He used to just say it's in a "zone of reasonableness", but this time said that if interest rates stay at current low levels, the stock market is cheap, and if interest rates normalize, it is expensive. Well, he has been saying for a while that stocks are better than bonds.

We know there is a relationship between interest rates and stock market valuation.  Some criticized the old Fed model (10-year bond yields compared to the earnings yield of the S&P 500 index) saying that there was a correlation between the two for only a short period in history but there hasn't been a correlation between them for most of history.  This is true, but it is also true that there is a logical connection between them so we can't deny a relationship just because we can't get some charts to look convincing.

Anyway, just for fun, I decided to play around with some figures.  My goal was actually just to see what the stock market should be valued at if interest rates normalize.  I did that before, but this time I wanted to do it empirically.

One thing I don't advocate or call for is for the stock market to catch up to the bond market.  If it did, then the P/E ratio of the market would get to 50x, and that's too expensive.  At that level, even I would pound the table to get out of the market.

So first of all, we've already seen the many charts comparing bond yields to earnings yields and how they have tracked each other closely (and diverged)  in recent years.  So I decided to look at it a different way; by X-Y plotting it.  This is nothing new; strategists do this sort of thing all the time (as I used to too back in the old days).

This is the data from 1871 through the end of 2014.  The earnings yield is on the Y-axis and the 10-year bond rate is on the X-axis. (all data is based on the S&P 500 index (and predecessors for older data), ttm earnings from Shiller's website).


Earnings Yield Vs Bond Yield 1871 - 2014
        (x=bond yield, y = earnings yield)


Wow.  Looks like a raptor claw.  So the Fed model critics are right.  The R² is basically zero. But we knew that.

The two vertical clusters are from the era when interest rates were low.  The cluster to the left is when rates were around 2% and the stock market got cheap in the late 1940's and early 50's.  The second vertical cluster (or claw) was when the market swung around in 1915-1920.    Excluding those two periods, there seems to be sort of a linear relationship.

So let's see what happened since 1955:

Earnings Yield Vs Bond Yield 1955 - 2014
        (x=bond yield, y = earnings yield)

Now we see a little bit more of a clear slope, verified by the higher R² of around 0.4.

Not that different, but here it is from 1970:

Earnings Yield Vs Bond Yield 1970 - 2014
        (x=bond yield, y = earnings yield)


We can see that the stock market didn't continue down the slope as rates declined.  The dots all the way at the bottom when interest rates were between 2% to 4% and earnings yield dipped below 2% was just from the financial crisis; the E declined dramatically.

Eye-balling this chart, even if rates got back up to 6%, the stock market valuation would still be reasonable; no need for a valuation adjustment.

Just for fun, I took out the data after 2007.  Let's look at this from 1980-2007:

Earnings Yield Vs Bond Yield 1980 - 2007
        (x=bond yield, y = earnings yield)

Obviously, the  R² increases and the slope gets closer to 1 (0.8367).

So we see that stock prices are cheap at current interest rates, but the thought is that they may become expensive if interest rates "normalize".

But what does it mean for interest rates to normalize?  From the above charts, it looks like the stock market can be in the fair value range even with rates going back up to 6% or more.

What is "Normal"?
People have been calling for higher rates for years now, so I won't quote anyone's guess on where they think rates will go.  Here's a chart I used in a post a while back about valuing the stock market using interest rates.  Since noone can predict interest rates, as a proxy, I used the nominal GDP growth rate as a level where long term interest rates should eventually settle.

Here's the chart that only goes to 2012, but since it's a long data series, it doesn't matter too much:



Of course, the problem with this is that yes, nobody can predict interest rates but to use this model we need to predict GDP growth and inflation.  Economist track records there aren't much better.

But we can at least see where rates would be without the "distortion" of central banks given reasonable assumptions.

For example, I have no problem with "normal" long term real GDP growth of 2.0%, and inflation in the 2.0%-3.0% range.  That gives us a range for nominal GDP growth of 4-5%.  So interest rates too, should be around there.  I have no problem thinking of 4-5% as the level of long term interest rates in a normalized environment with no central bank manipulation of long term rates (well, there will always be some sort of activity going on, but I just mean the massive QE-type thing).

Let's go back to the above X-Y plot charts.   I am going to go back to the chart from 1955 to include more data.  Data before 1955 may not be too meaningful, plus 59 years is enough data for this.

I drew vertical lines between 4% and 6%.  My question is, what is the average earnings yield (and standard deviation) of the stock market when interest rates were in this range?  Keep in mind that this interest range is far higher than where interest rates are now.

Earnings Yield Vs Bond Yield 1955 - 2014
        (x=bond yield, y = earnings yield)


When interest rates were between 4% and 6% since 1955, the stock market traded at an average P/E of 20.4x.  If you put standard deviation bands around the cluster, the range would be 16.6x - 26.6x for one standard deviation and 14x - 37.9x for two standard deviations.

If you expand the range to 4-7% or 4-8%, then the average P/E comes down to 14x, so in that case the market would look overvalued.  But I think a lot of the vertical dot cluster in the 7-8% range is from the 1970's.  Of course, we can't assume that won't happen again.

Just for fun, let's see these figures from 1980-2014.  Some will argue that this is no good since the market has been overvalued for most of the past three decades.  But again, let's just see for fun:

             Interest rate range            average P/E
                   4 - 6%                            23.3x
                   4 - 7%                            22.7x
                   4 - 8%                            21.6x

If you do it by constant range (instead of expanding it) you get:

               Interest rate range           average P/E
                   4 - 6%                             23.3x
                   6 - 8%                             19.6x

Using data since 1980, even if rates went up to the range of 6-8%, the market would be fairly valued at 19.6x P/E.

I actually don't agree with this; I would still value the market at closer to the inverse of the bond yield; a 6-8% interest rate range would suggest P/E ratios of 13-17x.

Shorting an Overvalued Market?
So people keep saying the market is overvalued.  If you are short the market because you think it's overvalued, then you would have to think hard about it.  The above suggests that the market is not overvalued even with interest rates going up to 6%  (well, I would view it as a little overvalued with rates at 6%).  If you think the market is overvalued, then you have to think that bond yields have to go higher than 6%.  But then if that is the case, it's probably a better trade to just short the bond market.

When you say the market is overvalued, you are basically saying that interest rates are too low.  In that case, the bond market is even more overvalued than the stock market; the stock market has a big valuation cushion before rising rates start to hurt it whereas bond prices will get hit immediately.   In fact, if you believe in mean regression, then you would have to actually buy stocks and short bonds against it.

Of course, there are other reasons to be short the market, but I am just isolating this one component, valuation.

If you look at long term charts of market valuation, it looks really high and scary, but the above shows that in this environment, things are pretty normal.

If you do assume that a 1970's event is coming soon (and this view is not so uncommon), then shorting stocks and bonds might be a great idea.  But even then, you have to keep in mind that if you do short expecting a 1970's-type event, you are betting on an event that occurs very infrequently. How many interest rates spikes and inflationary events have we had in the past 100 years?

As Buffett likes to say, it's not smart to bet on low probability events.   (It's just as dumb to assume that low probability events are zero probability events!)


Conclusion
I don't know why, but I suddenly just wanted to do this.   I guess Buffett's comment made me think about market valuation again and made me wonder what "normal" interest rates are and where the market should trade in that case. Sometimes it's fun to plot some data to see what things look like.

I am more comfortable comparing bond yields and earnings yields directly as Buffett does in his discussion about market valuation (which I excerpted in length here:  Buffett on Market Valuation) without going through all of this.

From this, though, we can conclude that even if long term interest rates pop up into the 4-6% range, the stock market is still in the fair value range; the market is trading now at just about exactly the average level the market has traded at when interest rates were between 4% and 6% since 1955.

Yes, moving that range up to 7% or 8% moves the average down to a 14x P/E, but most of that vertical cluster is from the 1970's (note the lack of that cluster since 1980).  The same figures for data since 1980 shows much higher valuation levels (but maybe biased on the high side).

If we are constrained in growth as economies around the world mature, then normal interest rates may not go too far above the 4-6% range. If that's the case, the stock market looks fine.


Wednesday, May 13, 2015

the missing manual: Berkshire Hathaway / Warren Buffett


New Book?! 
OK, so there isn't really a book with this title.  I was just having some fun.  Don't waste your time Googling or Amazoning it.  It doesn't exist. In this day and age, you can't always believe what you see.

But you know, this is exactly what I was thinking as I was reading through some of the comments coming out of the annual meeting.

There were some tough questions raised this time and some shareholders didn't seem pleased with the answers.

Also, not too long after that, a hedge fund manager criticized Buffett calling him a hypocrite.  He apparently backtracked later and said he was only kidding. I think he made these comments because Buffett, at the annual meeting, disapproved of the pretend reinsurance companies; reinsurance was just a 'front' (beard) for what is actually a hedge fund.

I think the criticism against Buffett was a response to that comment.

Anyway, I thought I'd just chime in on what I think about these respective issues that came up.  I don't think I have much to add to what has already been said somewhere on either side of each argument; these are just some thoughts that came to mind as I read about them. Plus, it's an excuse to post this fake book cover I made to the public.

Clayton Homes
One issue was about the lending practices of Clayton Homes.  I read the article (that reported on lending abuses at Clayton) and searched online for complaints and there are some horrible stories there.   Buffett responded that there have been few complaints to his office, few investigations and fines in a highly regulated business.  Clayton sells something like 30,000 homes per year so that says something, how few complaints there are.

I found one Better Business Bureau (BBB) site that shows 172 complaints over three years, but that's only one region.  I don't know what that figure is nationally.  Other websites have nightmare stories about Clayton too, but that doesn't really tell me anything.

If you Google even your favorite restaurant, there will be a few horror stories.  The only problem is that it is a lot more likely for people who had a great meal to write a review on how great their experience was than for people who buy manufactured homes and had a great or normal experience.  The review sites for manufactured homes tend to be nightmare sharing sites.  For me, I need to know what the total figures are, not how bad the few horror stories are.   As far as I'm concerned, Buffett gave those figures.  He said he gets no complaints and has had very little regulatory problems.  Plus the fact that they keep the loans on their books is pretty important; they retain the risk.

Also, we have to keep in mind the nature of the business.  I don't even trust your average real estate agent.  I think they are mostly full of it and don't believe what they say; they'll say what they need to say to get the deal done (well, apparently bond traders do that too!).  Of course there are good and bad agents, just like anywhere else.  I tend to believe that most people are honest, though, and try to do the right thing.  A few bad apples won't spoil it for me (e.g., despite all I heard from the financial crisis, I still like and respect Goldman Sachs).

With respect to problems with the product itself (the homes), I was warned a long time ago by a real estate lawyer in NYC to avoid new construction.  She has done many real estate deals over her long career and in most new constructions there were problems.  It takes a few years for the building to get debugged, and possibly some lawsuits to get the repairs paid for by the developer.  She said let others deal with that headache and just find something that has been working fine for a while already.
So it's kind of not surprising reading about Clayton complaints on the product.   I hear about problems all the time on just about every other construction/renovation etc.  With big projects, there are going to be problems.  This is not a business like delivering pizzas, books or CD's.

In any case, for me to worry about Clayton, there would have to be real numbers, not just a few anecdotes here and there.  There has to be reason to believe that this is an actual, widespread, systemic problem and not just a few problem situations here and there.

This is not to say that we shouldn't question these things.  It's good that this question was raised and Buffett answered them.  It seems like a lot of people were not happy with his response, but I don't know.  He seems to have brought some facts and figures with him so I'm OK with that.

3G Capital
The other concern was that Buffett is getting involved with 3G Capital, a private equity firm.  Buffett has answered this question before, explaining that 3G is not like other private equity firms.  Other private equity firms do things for short term profits.  They need to maximize value and then realize it in five to seven years, so they don't have the long-term horizon that Buffett likes.

3G Capital buys to hold and to grow, not to flip after a few years.  The private equity business model is usually to buy something on leverage, cut costs and boost profits and then sell out (not all private equity firms are the same so I understand not all fit this description).  Cynics will say that the idea is to sell out on strong earnings at a high multiple before the drastic cost cuts start to impact the medium to longer term outlook of the business.

3G Capital doesn't do that.  They buy to own and build.

One journalist still couldn't get around the fact that 3G boosted earnings so quickly at Heinz.  He was confused with operating for the long term while boosting profits in the short term.  He thought, apparently, that they were mutually exclusive.  This is not the case at all.  Just because you boost earnings in the short term doesn't mean you are managing to optimize short term profits and not thinking long term.

If you buy a two-man business that is losing $500,000 / year and notice that you have one guy doing nothing but slurping cup noodles all day long (with no plans to do anything in the future) taking home $1,000,000 / year in salary and fire him, you will improve earnings from a $500,000 loss to a $500,000 profit.    Yes, this improves short-term profits, but it doesn't mean it was a bad long-term business decision. It is probably the right long-term thing to do too. (Well, in this case, there would be no long term without firing that guy!).

Buffett used the example of the railroad industry and farming; right-sizing is necessary in capitalism or else we'd all still be living on farms.  Munger used Russia as an example as an alternative to right-sizing (Russian laborers pretend to work and the government pretends to pay them).

I have another example, and that is the Japanese economy.  Japanese companies too are highly averse to right-sizing and they have paid a heavy price for it.  I read a few books a while ago on the growing problem in Japan of the "working poor", an increasing underclass of poor people in Japan.

The scary thing about this class of "working poor" is that many of them are highly educated former employees of large companies or owners of small to mid-size companies.

What happens is that the companies are so averse to right-sizing that when a firm ultimately and inevitably fails, the employees are unable to find work and end up in minimum wage jobs (working in a convenience store like a Seven-Eleven is apparently common).  Suddenly, these people who drove Mercedes and BMW's were working the cash register on the night shift at the local Seven-Eleven.

The problem with middle management is that much of the time, the skill set acquired at one company is useless anywhere else.  Middle managements often have no skills to bring to other firms.  So when you don't right-size, you have a potential disaster in the making.  Plus, when nobody down-sizes, there is no active labor market.

Jack Welch used to say that firing people is doing them a favor, and keeping them on the payroll when they shouldn't be is bad for them and for the economy.  It sounds mean and harsh, but having seen what's going on in Japan, he is so exactly right.  The sooner excess labor is let go so they can go acquire a new skill or new job, the better.  If you wait until everyone gets too old and then have to fold up the shop, it's too late;  employees will have been doing nothing for too many years/decades to be of use to anyone else.

So anyway, I have no problem with how 3G Capital operates, and I actually think it is good for the economy.  This labor fluidity is necessary.

As for Buffett being involved in this sort of thing, he owns large stakes in companies that are highly efficient.  His private businesses are businesses he bought because he liked how they are run.  There is no inconsistency there. I think Buffett appreciates it when Wells Fargo and American Express (and others) right-size when necessary (so that massive layoffs all at once becomes less likely).  And they have been doing that for decades.  Again, no inconsistency.

Coke
Some people think that Buffett is missing the boat on the trend towards healthier lifestyles.  I sort of feel that way too.  But Buffett has a good point.  We've been here before.  He said that there was an article calling for the end of Coke in the 1940's, I think.  People were unhappy with his purchase of KO in 1988.

Trends do come and go.  We've had these health booms in the past.  I remember some of them.  At one point, people were avoiding carbs like the plague.   And the hottest restaurant concept these days is Chipotle Mexican Grill (burritos and tacos, and yes, for those Atkins holdovers, bowls).

Red meat was evil not too long ago, and now we have a huge hamburger boom, Shake Shack just being the latest in this trend.

IBM
There was some discussion about IBM too during the annual meeting.  It is interesting that the argument against IBM is that their mainframe business is dead and that they won't be able to catch up with the cloud.  Buffett/Munger pointed out that IBM has been through technology cycles before and has come through fine.  They used to dominate punch cards, but that business doesn't exist anymore and they evolved to the next thing.

The key is the client base, and Buffett seems confident from his discussions with CEO's that IBM clients are going to stay IBM clients for a while.  And he has a pretty good sampling, just within Berkshire Hathaway and the stock holdings.

Also, I haven't done any work, but I rarely hear discussion about IBM's consulting business; somewhere within that beast (or dinosaur) is the old PWC Consulting, and Accenture is a listed company with a 20x P/E ratio.  I don't know how that figures into the argument, but it must fit in there somewhere.  It's not just about mainframes versus cloud, I don't think.

Moving on...

Buffett Ran a Hedge Fund!
Moving on to the "Buffett the hypocrite" thing.   Buffett often criticizes hedge funds (and private equity funds and investment banks too).  He criticizes them for their high fees.

Well, yes, Buffett ran a hedge fund too but he didn't take a management fee.  He only took incentive fees above 6%, I think, with no catch-up provision.  He takes 25% of gains above 6%, so if the fund returned only 6%, he would have gotten nothing.

The standard these days is 2 and 20, which is 2% management fee and 20% incentive fee.   With expected return in stocks, at most, of 10%, that's a lot.  If a fund returned a gross 10%, the net return to the investor would be 6% (before tax!).  So the hedge fund manager would be taking home 40% of the gain.  With Buffett's structure, a gross return of 10% would result in a net gain of 9% for the investor.  Not a bad deal.

Also, Druckenmiller called people who invest in funds with a 2 and 20 structure "idiots" or something like that.  He didn't criticize the funds, but the investors.  He said that during his time in the industry, hedge funds with that kind of fee structure were expected to earn 30-40%/year (or something like that; maybe he said 20-30%).  And he pointed out that they were expected to do well in good markets and bad markets.  He says it's nonsense when managers earn low returns but tout returns on a "risk-adjusted" basis.

But going back, Buffett criticizes the high fees and also the fact that most funds don't perform well.  Buffett's record as a hedge fund manager is well-known.  He had incredible returns and a much friendlier fee structure.

So as far as I'm concerned, there is no hypocrisy here at all.  His fee was fair, and he performed.  For the record, I don't have a problem with hedge funds or their fees.  I think it's up to investors to vote with their feet.  If a manager deserves the high fees, fine.  If not, the investors are dumb.  So what?  Hedge fund investors are presumably either professional institutions or accredited, "sophisticated" investors.  I have more of a problem with products marketed to retail, with fees layered upon fees, much of them hidden (annuities) etc... (12b-1 fees, loads, management fees for perpetual underperformance etc.)

Buffett is/was an Activist!
True that, too.   He has been involved in some situations, but it seems like they were reluctant situations and he didn't like hostile situations.  I think he backed away from things that seemed hostile a long time ago.  Otherwise, yes, he will still be involved in situations where he thinks he might be able to help.  He was active behind the scenes at Coke not too long ago, for example.

But I think the beef he has with activism these days is that they seem to be too short-term oriented; lobbying companies to make moves that will boost the stock price in the short term so that the activist can sell out at a profit.  I think his views of the GM situation earlier this year shows exactly what he didn't like about activism.  If Berkshire Hathaway is an example of his activism, it's a great one; he still owns it after all these years!  I think he has acknowledged in the past that some activism is good.

I too think it's good to a point.  When most shares are held by big mutual fund companies and those mutual fund companies run the 401K plans of the companies they own shares in, I think that might lead to problems.  I think someone has to occasionally step up for the shareholders and rattle the cage a little bit.  I guess the debate would be more about where you draw the line.  Which activist situations were good, and which ones were bad?  DuPont recently is a good case study (I have no opinion either way other than to say that it is interesting!).

Buffett Doesn't Pay Taxes but Wants Others to Pay More
This is one thing that keeps coming up over and over again and it's really annoying to me.  They say that Buffett is calling for higher taxes for the rich and yet he does all he can to avoid taxes.  They say, if he wants the rich to pay higher taxes, why doesn't he just pay more taxes himself?  Let him pick a fair rate and then pay that himself to the government.

I never understood that argument.  It is ridiculous.  Buffett's idea is to raise revenues for the government, and one person like Buffett paying voluntary taxes is not going to move the needle.  (well, some will say that taxing the rich won't move the needle either).

Here goes a bad analogy, but it's like saying, hey, if you want the whole country to lose weight and want to implement limits on the size of soft drinks, just limit soft drinks for yourself!   Well, great.  Limiting soft drinks for yourself might help your own health (possibly, but according to Buffett/Munger, maybe not!) but will do nothing for the country.  I don't mean to debate if this would work anyway.  But the point is, if you want to make a change for the country and advocate policies, you can't just do something yourself and think that will solve the problem.

Buffett's tax thing is like that.  He pays all the taxes that he is required to pay.  He has donated most of his wealth to charity and avoided a huge tax bill, but I don't even know if that was his primary motive to give to charity.  He was clear from early on that he didn't want to give his kids too much money.  The alternative is to give to charity, which happens to be tax free.

For the record (who cares what I think?), I am no advocate of higher taxes.  A much better idea would be to have 3G Capital run the government.  They don't have to become president; they just need to run the operations; Post Office, Amtrak, and everything else!

Conclusion
So anyway, I know all of these things are big topics of debate and I can't say who is right or wrong. I just posted what I personally think about these things.






Friday, April 17, 2015

Seaboard Corp (SEB): The Other Protein Trade

This is a post I wrote up a while back and never published as Kraft/Heinz and other things happened.  Anyway, here it is:

In December 2011, Leucadia (LUK) bought 79% of National Beef.  They explained the purchase as a play on the rising consumption of protein around the world as incomes rise in emerging economies (as poor countries get richer, they eat more meat).   Most important, though, is that they liked the management.

From the 2011 LUK letter to shareholders (still Cumming/Steinberg):
As our faithful investors know well, we have long watched and commented on global commodity consumption patterns. We continue to believe that as citizens of historically poor countries get richer they will demand higher quality items . and more of them. We believe this thesis is applicable to global protein consumption. While protein production and consumption in the U.S. is a mature market and is not growing, global protein consumption is growing at an astounding rate. U.S. beef exports were up over 22% in 2011 vs. 2010. This is an impressive number, made even more so by the fact that the U.S. is not allowed to export beef directly to China . not yet, anyway. 
and then after some detail about National Beef, they conclude:
In October the number of people on the globe reached 7 billion and is expanding exponentially. Humans need protein, we have it! 
And about management: 
We would not have made this investment were it not for our belief that we have the best management team. Tim and his management team are widely regarded as the best operators in the industry and we have confidence that these seasoned beef executives will guide National Beef through the inevitable rough patches. 

Also, at the 2012 annual meeting,  Steinberg said that the LUK portfolio was geared for inflation, and that if you don't believe inflation is coming, you should sell LUK stock.   Well, he was certainly right about that.  Inflation hasn't come yet and LUK stock also has done nothing since then.   I think for LUK, this "protein trade" sort of fit into that scenario.

And just as a refresher, here is a spreadsheet I put together at the time showing what the National Beef business was like:

National Beef Financial Summary

Beef 
NetCost ofGrossSGA%OpOperPretaxPretaxsoldEBITDAEBITDA
salessalesmarginSGAsalesD&AincmarginincomemarginCapex(bn lbs)EBITDAmargin- capex
20002,8252,6974.53%210.74%15923.26%893.15%191073.79%88
20013,0702,9464.04%240.78%16832.70%812.64%41993.22%58
20023,2473,1263.73%230.71%18802.46%782.40%21983.02%77
20033,6623,5163.99%270.74%20992.70%892.43%343.31193.25%85
20044,0943,9742.93%300.73%21691.69%441.07%333.1902.20%57
20054,3394,2302.51%310.71%24541.24%210.48%183.4781.80%60
20064,6364,5042.85%340.73%29701.51%390.84%353.7992.14%64
20075,5795,4442.42%430.77%32601.08%220.39%424.1921.65%50
20085,8475,6124.02%440.75%361552.65%1272.17%604.01913.27%131
20095,4495,1874.81%430.79%441753.21%1452.66%413.92194.02%178
20105,8085,4386.37%490.84%502714.67%2494.29%504.13215.53%271
20116,8506,4735.50%520.76%512733.99%2623.82%684.03244.73%256
Averages
3 years6,0365,6995.56%480.80%482403.95%2193.59%534.02884.76%235
5 years5,9075,6314.62%460.78%431873.12%1612.67%524.02293.84%177
10 years4,9514,7503.91%380.75%331312.52%1082.06%403.71633.16%123

I only put this here for reference, so hold this thought for a second.


Seaboard Corp (SEB)
Anyway, at the time we looked at another protein play.  Check out the original post.  National Beef hasn't been doing too well, but SEB has been doing really well.  Here is an update on their long term performance:

Net Net TotalShareholders'BPS
SalesearningsEPSAssetsequityROEBPS%chgpriceP/B
1989518,75918,678$12.56367,801189,448$127.36
1990557,32830,049$20.19422,488218,75315.86%$147.0615.47%
1991875,87421,241$14.28458,045239,2509.71%$160.849.37%
19921,053,65531,075$20.89485,121269,58112.99%$181.2312.68%$185.001.02
19931,142,14435,891$24.13647,332304,35613.31%$204.6112.90%$186.000.91
1994983,80435,201$23.67675,211346,08011.57%$232.6613.71%$161.000.69
19951,173,97720,202$13.58878,132365,8105.84%$245.925.70%$269.001.09
19961,464,3625,846$3.931,004,685369,9341.60%$248.691.13%$266.001.07
19971,780,33330,574$20.551,124,385399,0158.26%$268.247.86%$440.001.64
19981,294,49231,427$21.121,215,897444,7287.88%$298.9711.46%$422.001.41
19991,284,262-13,587-$9.131,249,022443,168-3.06%$297.92-0.35%$194.000.65
20001,583,6968,872$5.961,274,234540,6852.00%$363.4822.00%$156.000.43
20011,804,61051,989$34.951,234,757528,4209.62%$355.24-2.27%$306.000.86
20021,829,30713,507$9.381,281,141486,7312.56%$387.829.17%$242.000.62
20031,981,34031,842$25.371,325,691520,5656.54%$414.776.95%$282.000.68
20042,683,980168,096$133.941,463,694692,68232.29%$551.9133.06%$998.001.81
20052,688,894266,662$211.941,816,3211,013,90438.50%$803.8145.64%$1,511.001.88
20062,707,397258,689$205.091,961,4331,242,41025.51%$984.9722.54%$1,765.001.79
20073,213,301181,332$144.152,093,6991,355,19914.60%$1,089.1410.58%$1,470.001.35
20084,267,804146,919$118.192,331,3611,463,57810.84%$1,179.908.33%$1,194.001.01
20093,601,30892,482$74.742,337,1331,541,6736.32%$1,249.575.91%$1,349.001.08
20104,385,702283,611$231.692,734,0861,775,20618.40%$1,462.5217.04%$1,991.001.36
20115,746,902345,847$284.663,006,7282,078,92419.48%$1,717.7217.45%$2,036.001.19
20126,189,133282,311$234.543,347,7812,304,55013.58%$1,927.2512.20%$2,530.001.31
20136,670,414205,236$171.923,418,0482,475,2498.91%$2,085.848.23%$2,795.001.34
20146,476,076365,270$309.963,677,3202,715,89814.76%$2,320.1911.24%$4,198.001.81
5 yearaverage15.02%13.18%1.40
10 yearaverage17.09%15.44%1.41
20 yearaverage12.22%12.19%1.19
All dataaverage12.31%12.31%1.17

(ROE is return on beginning equity)

And in the original post, I compared SEB to BRK and the S&P 500 index (total return).  Since it's good to look at things through cycles, I used December 1999 as the starting point as that was sort of a big, major top.  I think I used the end of 2000 last time, but here I changed it to 1999-end.

SEB BPS versus BRK BPS and S&P 500 Index Total Return  (Dec. 1999 = 100)

SEB has done really well and has continued to outpace the market and BRK.

Here is the performance over various time periods:

                                      SEB              BRK          S&P 500 (total return)
One year:                      +11.5%           +8.3%      +13.7%
Five year:                     +13.2%         +11.6%      +15.5%
Ten year:                      +15.4%         +10.1%       +7.7%

Since 1989:                  +12.3%         +15.2%       +9.6%
Since 1999:                  +14.7%           +9.4%       +4.3%
Since 2007:                  +11.4%           +9.4%       +7.3%

SEB and BRK are annualized changes in BPS, and yes, I know the BRK BPS growth rate is understated.  Look at the performance from the two peaks, 1999 and 2007.  Good stuff.

BPS?!
There is a question as to whether SEB can be valued using book value.  Typically, operating companies like this are not valued using book value.  But I found it to be a convenient measure for SEB because they seem to operate as more of a capital allocating conglomerate like some of the others we talk about here.  SEB has evolved over the years by buying and selling businesses so it seems like a good idea to see how value has been added over the years.

Also, the businesses they are involved in seem to be cyclical so it's hard to take any given year's earnings and slap a P/E multiple on it.  If we see some consistency in ROE or growth in BPS over the years, it would be easier to value the whole based on that; what kind of ROE or BPS growth have they achieved in the past?  What is a normal rate of growth through cycles?  What is a normalized earnings level based on current equity capital?  And then what kind of multiple can we put on that?  Or what kind of multiple to BPS is fair for the business?

So anyway, there are a lot of ways to look at this, but BPS for me seemed like a good way.

The short term returns above (one year and five year BPS growth) is higher than BRK's BPS growth but lower than the S&P 500 index total return.   As many have pointed out (to explain their own underperformance), that is due to the S&P 500 index coming back from a crisis low.

On a ten year basis, SEB has done really well compared to both BRK and the S&P 500.  SEB lags BRK on the measure starting in 1989, but not many can outdo BRK over that long a time period.

But SEB has beaten both from the two recent peaks; 1999 and 2007.

So What's it Worth?
SEB's biggest business is the pork production and processing business.  My impression has been that this business doesn't usually carry a high multiple.  Smithfield Foods was taken out in 2013 at 9.4x EV/EBITDA and 14x EBIT (using the announced $7.1 billion figure).

Here is the table from the August 2013 Smithfield merger proxy showing valuation of listed comps:

  2013E P/E  3-Yr  Avg
Proj P/E
  EV / 2013E
EBITDA
  3-Yr  Avg
EV / Proj
EBITDA
Range of the selected companies
  11.2x - 20.4x  9.5x - 18.5x  5.8x - 11.8x  4.6x - 8.5x
Range of the selected Protein companies
  11.2x - 15.3x  9.5x - 18.5x  5.8x - 7.4x  4.6x - 8.1x
Range of the selected Packaged Meats companies
  16.6x - 20.4x  11.3x - 16.2x  8.3x - 11.8x  6.1x - 8.5x
Hormel Foods Corp
  20.4x  16.2x  11.8x  8.5x
Hillshire Brands Company (1)
  19.6x  N/A  9.5x  N/A
Maple Leaf Foods Inc.
  16.6x  11.3x  8.3x  6.1x
Sanderson Farms, Inc.
  15.3x  18.5x  7.4x  8.1x
JBS S.A.
  11.2x  13.3x  6.8x  7.0x
Tyson Foods, Inc.
  11.4x  9.5x  5.8x  4.6x
The Company
  10.9x  9.2x  6.9x  5.6x


And here is a list of precedent transactions:

Announcement Date
Target
Acquiror
Transaction
Value /
LTM
EBITDA
5/21/2010
Michael Foods GroupThe Goldman Sachs Group, Inc.7.7x
9/16/2009
Pilgrim’s Pride Corp.JBS SA8.0x
6/24/2008
StarkistDongwon F&B Co., Ltd.7.8x
5/29/2007
Swift & Co.JBS S.A.7.7x
9/18/2006
Premium Standard Farms, Inc.Smithfield Foods, Inc.6.0x
7/31/2006
ConAgra Foods, Inc. Branded Meats BusinessSmithfield Foods, Inc.5.8x
6/27/2006
Sara Lee Corp. European Meat BusinessSmithfield Foods, Inc.6.0x
1/1/2001
IBP, Inc.Tyson Foods, Inc.7.3x
As part of its analysis of precedent transactions involving companies in the meat/protein industry, Barclays calculated and analyzed, among other things, the ratio of the transaction value to LTM EBITDA, based on such target company’s LTM EBITDA for the twelve months prior to the transaction.
All of these calculations were performed based on publicly available financial data. The results of this precedent transaction company analysis are summarized below:

Transaction Value/LTM EBITDA
Mean
7.0x
Median
7.5x
High
8.0x
Low
5.8x

The bankers concluded that 7-8x is a fair multiple to use for Smithfield.

Hillshire Holdings was acquired by Tyson last year for 16.7x ttm EV/EBITDA, but (according to Tyson) 10.5x ttm EV/EBITDA if you include $300 million in expected synergies.

Let's look at some metrics of Smithfield and Hillshire:

Smithfield
                         Operating                  EBITDA
                         margin                       margin   
2009                 -1.8%                         0.4%
2010                  0.6%                         2.7%
2011                  5.1%                         7.0%
2012                  5.5%                         7.5%
2013                  3.8%                         5.6%      
average              2.6%                        4.6%


Hillshire
                         Operating                 EBITDA
                         margin                      margin    
2010                 4.6%                         8.0%
2011                 5.8%                         8.8%
2012                 1.9%                         6.0%
2013                 7.6%                       11.3%
2014                 7.5%                       10.7%       
average             5.5%                         9.0%


Now go back and look at the spreadsheet for National Beef at the top of this post.  You will see that margins in this business tend to be really low.  Even for companies with value-added products like Smithfield and Hillshire.

Now look at the metrics for SEB's pork segment:

SEB Pork Segment:
OperatingEBITDA
marginmargin
1998-0.19%
19996.33%9.83%
20008.69%11.59%
20018.94%11.79%
2002-2.17%1.55%
20033.53%8.56%
200415.28%19.44%
200517.87%21.88%
200613.76%18.15%
20073.98%8.67%
2008-4.09%0.62%
2009-1.41%3.57%
201015.35%19.02%
201114.84%17.36%
20127.51%10.13%
20138.64%11.15%
201420.33%23.01%
average8.07%12.27%
Five years13.33%16.13%
Ten years9.68%13.35%
This is segment information from the 10-K, so there would be other costs not included here (corporate).  So this may not be directly comparable to the above comps.  But if you take the unallocated expenses (corporate expense not allocated to any of the operating segments), it still amounts to less than 2% of the sales of the pork segment.  So if you allocated ALL of that corporate to the pork segment, it will reduce margins in 2014 by 2%.

Valuation Matrix
OK, so I was working on this post before I wrote up the stuff on MKL.  But I was sort of thinking the same thing in evaluating MKL.  Why not use some sort of valuation matrix by taking some normalized level of earnings and some sort of earnings multiple on it?   Another way to look at it is to look at SEB as a sum-of-the-parts of the various segments, but you will notice that each segment tends to have volatile earnings so it's hard to see what a normalized level of anything would be.

So I figured looking at the whole might be easier. 

Going back to the above long term performance table, you will notice that since 1989, SEB grew BPS at 12%/year.  This is the same as ROE (return on beginning equity, in this case).

Of course, we can just look at the historic P/B ratio and say that SEB should trade at 1.2x BPS because that's the average it has traded at since 1989.  Or maybe it should trade at 1.4x BPS because that is what it has traded at in the last five and ten years.

For the record, SEB has traded at an average of 14x P/E since 1989, and around 11x P/E for the last five and ten years.

Judging from the long term performance, it's probably pretty clear that 1.0x - 1.2x BPS is pretty cheap.  Five and ten year growth in BPS has been 13% and 15% respectively.

So let's say a long run, normalized level of earnings at SEB is around 12% ROE.  And then let's say that SEB has such a great performance that it should trade at least as high as what the average U.S. company has traded at over time (14x P/E).

Pulling out the valuation matrix, we get:

P/E
%growth789111213141516
8%0.560.640.720.880.961.041.121.201.28
9%0.630.720.810.991.081.171.261.351.44
10%0.700.800.901.101.201.301.401.501.60
11%0.770.880.991.211.321.431.541.651.76
12%0.840.961.081.321.441.561.681.801.92
13%0.911.041.171.431.561.691.821.952.08
14%0.981.121.261.541.681.821.962.102.24
15%1.051.201.351.651.801.952.102.252.40
16%1.121.281.441.761.922.082.242.402.56
17%1.191.361.531.872.042.212.382.552.72
18%1.261.441.621.982.162.342.522.702.88

1.7x BPS might be a fair value of SEB if it continues to earn 12% (or grow BPS by that much) over time and it trades at a long term average multiple of U.S. stocks.

If SEB trades at it's own five to ten year average multiple of 11x and continues to grow BPS at 12%, then it's worth 1.3x BPS.  

With growth of 10%/year, at 11x P/E, that's a 1.1x multiple.  At 14x P/E, it's worth 1.4x BPS.

SEB closed yesterday at $3,670/share, or around 1.6x BPS.  It's seems a little high on a historical P/B basis, but if SEB's performance since 2004 is structural and not cyclical, then it is possible that SEB trades at a higher P/B in the future.

The sharp rally in 2014 was probably due to the abnormally high profits they earned in the pork segment (due to spiking prices caused by the pig virus), and also probably as a Cuba play.  SEB may well benefit from any increasing trade with Cuba (Marine segment) but who knows.

Conclusion
SEB is doing well.  Some short term factors may have pushed the stock price up too much, but looking at the tables above, it looks like there also may be a reason for SEB to trade at a higher valuation over time than before.  It does seem to be a higher quality business than some of the comps.