The Word 'Quaint' Comes to Mind

 | Feb 27, 2012 | 5:45 AM EST  | Comments
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Warren Buffett wants you to buy his stock. He is pleading with you to do so -- begging you. He's talking about its substantial undervaluation. He's making it very clear that the market truly does not understand his company. He is also making a compelling case for why it is so much cheaper than he has ever seen it.

Here's the problem: The metrics he uses to evaluate and substantiate the undervaluation are quaint and, frankly, atavistic in this era.

Now, I know what you might be thinking: Sure, Cramer, that may be true in this momentum-driven go-go era, but Buffett's methods will hold up long after that era is over.

But I am not speaking about momentum investing. I deride that myself. I am speaking about the era in which people measure stocks by the dividend return -- the payout. That, frankly, is something that's been important for a millennium, if not longer, according to Jeremy Siegel's excellent work at Wharton.

In fact, I would go a step further in saying that Buffett's methods are both anachronistic and, yes, empirically false, as gut-wrenching as that may be to hear. That's because they are based, first, on an old benchmark that has lost relevance for a generation -- book value -- and another benchmark that has lost its gravitas in the most recent brutal 12 years of lost performance.

Before you call me a know-nothing heretic who is denigrating the greatest investor of our time, let me acknowledge that he is a brilliant buyer of companies, a brilliant operator and was, at one time, a brilliant stock-picker. Two out of three ain't bad, particularly for his age.

But to give him three out of three is to denigrate others who have done a much better job at isolating companies that have performed well in this era. Anyway, name me a mutual fund or a hedge fund that is even one out of three, the first two well beyond the ken and the dictum? In other words, I acknowledge that he has the most all-around solid package in a flawed world.

I will also freely acknowledge that his Berkshire-Hathaway (BRK.A) company is indeed undervalued as an operating company. But that's because of its impenetrability, which this most recent letter does a lot to combat.

It's a pleasure to see, point-blank, how Berkshire really does make its money. Berkshire is an insurance company with a housing subsidiary, a rail subsidiary, a pipeline subsidiary and a subsidiary of eclectic enterprises. At all times the synergy comes only from being able to plow the profits into other investing entities, and Buffett correctly and pointedly notes that investing entails taking money that could be spent now and making it, so there is more to spend later. It's pretty puritanical when you think about it.

Nevertheless, his reliance on book value and on buybacks is, indeed, atavistic in the first and a tad disingenuous in the second. The book-value metric is fine if it can somehow be be brought out. But that's quintessentially not going to happen. Buffett makes it a cardinal principle not to sell anything, and he certainly isn't going to sell the enterprise. So how does book value matter? If it can't be realized in any way as a method for stock appreciation, since it is not appreciated as a metric by the investing firmament, then so what? Yes, let's be real crass: So what?

I found the whole buyback portion of Buffett's annual essay to be hypocritical, as well as tautological in the extreme. First he talks about how management teams are smart to do buybacks when they are sure that they'll be a great use of capital against hard benchmarks like book value. Then he says Berkshire is deeply discounted vs. book value. Then he admits that he has bought back only a thimbleful of stock -- and he says that he doesn't use price breaks to buy.


If you believe your company is undervalued by your own benchmarks, than you are being obtuse, stubborn or hypocritical not to buy back stock.

That would be all well and good if it weren't for his stab at explaining why he wants one of his most important holdings to be weaker: IBM (IBM). For me, one of the most discouraging aspects of Buffett's letter is his discussion on how it will be good if IBM goes lower while the company is buying back stock. That's because, while this is both ironic and deliciously counterintuitive, it is also wrong for anyone in the business of trying to make money with stocks.

Let me give you three reasons why I found it discouraging:

1. While Buffett praises the IBM buyback, there is simply nothing in this letter, or in general, that makes the case that this stock is at all undervalued enough to meet the Buffett standard of a justifiable buyback. Not book value. Not earnings per share. Not even intrinsic worth. Nothing. Nada. In fact, IBM is expensive vs. its revenue growth rate, and it's not even cheap against its earnings growth rate, which is simply juiced by the buyback anyway.

2. You don't want a stock going lower if you are a performance manager or if you are an individual investor. You don't want to put money in something now that will be worth less in the future. Doesn't Buffett's own stance say that? Yet he praises the idea that if IBM's stock is weak it is better for the buyback and, therefore, better for shareholders. What's better for shareholders is either capital appreciation or dividends. That's what makes you richer. But Buffett's not bothered, at least in this example, about being richer.

In fact, I am still trying to figure out the correlation between why he would like a stock to go down and why he believes his stock should go higher. Maybe his stock should go down so he can buy more at better prices. But is that what I want? If Berkshire paid a dividend, I could evaluate the worth on traditional metrics. In other words, the lower Berkshire shares would have gone, the higher the yield would have been, which would therefore have attracted me. But Buffett doesn't want to give you a good dividend, nor does he feel the need to be a dividend aristocrat like so many of the companies in which he invests.

3. Finally, I like Apple (AAPL) more than IBM because I like growth. Buffett praises and prides growth in his own private portfolio, but he doesn't do so in his public holdings. This is mystifying -- because, if performance matters, Apple is the better stock. Again, though, for Buffett this doesn't seem to matter, except when it comes to Berkshire, because he is unhappy with how the market's valuing his stock. By the IBM standard he articulates, he should be thrilled, except that he doesn't avail himself of why he likes IBM -- the buybacks -- himself.

One other concern, while I am at it: Why isn't Berkshire much more profitable than it is? First, Buffett doesn't care about anything other than the increase in book value. You can say, "Ah ha, that's earnings per share writ large!" But how about the price-to-earnings multiples? He doesn't think they matter. However, they do. It isn't quaint that they do, either. Given that Buffett is able to get preferred investments like those in Goldman Sacks (GS) and Bank of America (BAC), shouldn't Berkshire be blowing the earnings away instead of achieving the relatively small increase in book value that we saw this year?

I think so.

So, why do I believe he's still a great investor? Now's my chance to be tautological: because he is. He tells us he is, and we actually have to believe him, because he has done so well with his investments and his operations. If he hadn't made such a big bet on housing, he'd have done better. If the other insurance companies had shown discipline in underwriting, he would have done better. If he had bought better stocks, he would have done better.

All that said, he's done better than a lot of others.

Now, if that only mattered, we'd have done better owning his stock. At the end, as much as we would like to not use that weighing machine, it's the one that matters.

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