Get Your Next Financial Crisis Here...

Easily the best analytical piece of writing on China's economic problems I have come across. Its long but fun to read and contains a lot of investing nuggets. All you need to know about the next financial crisis, when ... it has already started, newsflow out of HK has it that Chinese mainland owners are busy selling their properties in HK (as they are most liquid), the squeeze is already beginning in China.

A Front-Row Seat 
By Worth Wray

Before I teamed up with John last July, I worked as the portfolio strategist for an $18 billion money manager in Houston, TX that, among its other businesses, co-managed (with an elite team of investors from the university endowment world) one of the largest registered funds of funds in the United States.

For a bright-eyed kid from South Louisiana, it was a life-changing experience. I had a front-row seat for every investment decision in a multi-billion-dollar portfolio for almost five years; and along with my colleagues and mentors in Texas, North Carolina, New York, Shanghai, and Singapore, I had the chance to meet and interact with a long list of the most sought-after hedge fund, private equity, and venture capital teams. I often found myself in the same room with honest-to-god legends like Kyle Bass, John Paulson, JC Flowers, and Ken Griffin … and I forged lasting some friendships with their portfolio managers and analysts. 

As you can imagine, the information flow was addictive. I spent thousands of hours poring over manager letters from six continents, doing my best to connect the global macro dots ahead of the markets and coming up with question after question for everyone who would return my calls. That experience plugged me in to an enduring network of truly independent thinkers, forced me to see the world from an entirely different perspective, and put me in an ideal position to figure out what it takes to navigate the unprecedented (not to say strange) investment challenges posed by a “Code Red” world.

Sometimes, combing through a mountain of manager letters felt like reading the newspaper years in advance. I remember watching with amazement as a free-thinking global macro investor named Mark Hart made a fortune for his investors by shorting US subprime mortgages and then shifted his focus to what he argued would be the next shoe to drop – a series of sovereign defaults across the Eurozone.

Mark explained how the launch of a common currency had allowed historically riskier borrowers like Portugal, Ireland, Italy, Spain, and France to issue sovereign debt for the same borrowing cost as Germany did… without any kind of fiscal union to justify the common rates. The resulting debt splurge led to a big increase in fiscal debts, drove an unwarranted rise in unit labor costs across the southern Eurozone, and essentially activated a ticking time bomb at the very foundations of the euro system. It seemed obvious that rates would eventually diverge to reflect the relative credit risks of the borrowers, but the market didn’t seem to care until it got very bad news from Athens. We all know what happened next.

Just as Mark and his team at Corriente Advisors had predicted, spreads blew out in Greece, then in Ireland, then in Portugal, then in Spain… and it now appears that Italy and France are veering toward a similar fate. When the euro crisis finally broke out, my colleagues and I were waiting for it, because Mark had already walked us through his playbook for a multi-act global debt drama.

Instead of blowing up in spectacular fashion, the Eurozone crisis has taken far longer to resolve than a lot of investors and economists expected (Mark, John, and myself included); but the euro’s survival thus far has been largely the result of extensive Realpolitik and an increasingly hollow narrative from Mario Draghi and the ECB laying claim to the wherewithal to “do whatever it takes” to preserve the single-currency system. Meanwhile, as Corriente understood, the likelihood of major defaults across the Eurozone rises every day that the ECB does the bare minimum to resist France’s and Italy’s slide toward deflation. It’s not over until the fat lady sings.

The point I am trying to make is that Mark saw the fundamental imbalances behind the global financial crisis in time to launch a dedicated fund in 2006, and he saw the root causes of the ongoing European debt crisis in time to launch a dedicated fund in 2007… precisely because he thinks of the global economy as one interconnected system peppered with a series of unstable and still unresolved debt bubbles. Mark is one of the most forward-thinking investors I have ever met and one of the best in recent decades at spotting the big imbalances that spell T-R-O-U-B-L-E.

I can’t tell you if he will be right about the next phase of the global debt drama. Predicting the actions and reactions of elected and unelected officials is next to impossible in a Code Red world, but some people have an eye for fundamental imbalances. And since Mark has been largely right in identifying the major debt bubbles that have plagued the world since 2007, John and I can’t comfortably ignore his warning.

As Carmen Reinhart and Kenneth Rogoff argued in their still-authoritative history of financial boom and bust over the past eight hundred years, “When an accident is waiting to happen, it eventually does. When countries become too deeply indebted, they are headed for trouble. When debt-fueled asset price explosions seem too good to be true, they probably are.”

The Bubble That Is China
Following his prescient calls on the subprime debacle and the European debt crisis, Mark identified in 2010 another source of instability that he warned could shake the global economy. And it took me by surprise. He warned that China was in the “late stages of an enormous credit bubble,” and he projected that the economic fallout when that bubble burst could be “as extraordinary as China’s economic outperformance over the last decade.”

To my knowledge, Mark Hart and his team at Corriente were the first of many global macro managers to anticipate a hard landing in the People’s Republic of China. Mark argued that the Middle Kingdom would land very hard indeed, popping speculative bubbles in the property and stock markets, sending foreign capital flying out the door, and triggering a rapid collapse in the renminbi … and even if the Chinese governmentcould manage its economy away from a deflationary bust, they would be forced to devalue the renminbi to do so. In other words, Mark saw a much lower renminbi under almost every outcome.
It was a mind-blowing concept to me that the main driver of global growth (at the time) could not only implode but even drag the rest of the world down with it.

I can’t share the original Corriente China presentation with you for legal reasons, but here are a few public notes published by the Telegraph’s Louise Armistead after she attended one of Mark’s presentations in November 2010. 

These may look like obvious observations today, the sort you can find plastered all across the internet, but very few people were actually paying attention four years ago. And the data has only gotten worse since 2010 as rampant credit growth and insidious shadow lending have continued to fuel greater and greater capital misallocation.

In the presentation, which amounts to a devastating attack on the prevailing belief that China is an engine for growth, the financier argues that ‘inappropriately low interest rates and an artificially suppressed exchange rate’ have created dangerous bubbles in sectors including:

Raw materials: Corriente says China has consumed just 65pc of the cement it has produced in the past five years, after exports. The country is currently outputting more steel than the next seven largest producers combined – it now has 200m tons of excess capacity, more that the EU and Japan's total production so far this year.

Property construction: Corriente reckons there is currently an excess of 3.3bn square meters of floor space in the country – yet 200m square metres of new space is being constructed each year.

Property prices: The average price-to-rent ratio of China's eight key cities is 39.4 times – this figure was 22.8 times in America just before its housing crisis. Corriente argues: “Lacking alternative investment options, Chinese corporates, households and government entities have invested excess liquidity in the property markets, driving home prices to unsustainable levels.” The result is that the property is out of reach for the majority of ordinary Chinese.

Banking: As with the credit crisis in the West, the banks’ exposure to the infrastructure credit bubbles isn’t obvious because the debt is held in Local Investment Companies – shell entities which borrow from Chinese banks and invest in fixed assets. Mr Hart reckons that ‘bad loans will equal 98pc of total bank equity if LIC-owned, non-cashflow-producing assets are recognised as non-performing.’

The result is that, rather than being the ‘key engine for global growth’, China is an ‘enormous tail-risk’.

(Louise Armistead, The Telegraph, “Hedge fund manager Mark Hart bets on China as the next ‘enormous credit bubble’ to burst.” Nov. 29, 2010)

The markets may damn well prove Mark right, along with a host of other managers who either jumped on his bandwagon or reached the same conclusions independently; but it seemed downright crazy in 2010 to think that the main driver of global growth could abruptly become its biggest threat within a few short years.

On a personal note, I obsessed over China’s culture, economy, and political system for years in college and then witnessed the country’s transformation firsthand during my time at Shanghai’s Fudan University in the summer of 2007. 

Then and later, I marveled at China’s strength relative to the developed world and the seemingly invincible central government’s ability to keep the economy chugging along with credit growth and fixed investment while it hoped for the return of its developed-world customers then mired in the Great Recession.

It wasn’t what I wanted to hear … but I had to accept that Mark could be right. He had clearly identified a major imbalance which has continued to worsen over the last few years, and now we are just waiting for the next shoe to drop.

Four years later, Chinese production is slowing in the shadow of a massive credit bubble and in the face of aggressive reforms.

Disappointing investment returns are revealing broad-based capital misallocation; property prices are cooling (relative to other countries); and commodity stockpiles are mounting.

With China’s new policy of allowing defaults (historically, China’s default rate has been 0%), there is a real risk that follow-on events could spin out of control, raising nonperforming loan ratios and sparking a panic as bank capital is significantly eroded.

In the meantime, the renminbi is trading down, most likely due to an intentional effort by the People’s Bank of China to aid in the slow unwinding of leveraged trade finance.

Now the signs of a Chinese slowdown (and thus a global one, as the world is geared to 8% Chinese growth) are clear, and people around the world are meeting uncertainty with emotion. With that in mind, let’s dig into the data that really matters and try to get to the heart of China’s dilemma.

China’s Minsky Moment?

“China is like an elephant riding a bicycle. If it slows down, it could fall off, and then the earth might quake.” – James Kynge, China Shakes the World

After 30 years of sustained economic growth topping 8% and a successful bank cleanup in 2000, the People’s Republic was well on its way to blowing through the “middle income trap” and transitioning to a more advanced consumption-based economy. But then in 2008 the banking crisis in the United States abruptly ushered in a painful era of balance sheet repair across the developed world and delivered a demand shock to emerging markets. Rather than allow the Chinese economy to fall into recession at such an inconvenient time, the Party leadership sprang into action to stimulate demand with its largest fiscal deficit in more than 60 years and to mobilize bank lending with historically low interest rates and enormous liquidity injections.

As you can see in the charts above, China’s total debt-to-GDP (including estimates for shadow banks) grew by roughly 20% per year, from just under 150% in 2008 to nearly than 210% at the end of 2012 … and continued rising in 2013. Even more ominous, corporate debt has soared from 92% in 2008 to 150% today against the expectation that China’s government would always backstop defaults. That makes Chinese corporates the most highly levered in the world and more than twice as levered as US corporates, just as  corporate defaults are happening for the very first time in more than 60 years.

By another measure, China has accounted for more than $15 trillion of the $30 trillion in worldwide credit growth over the last five years, bringing Chinese bank assets to roughly $24 trillion (2.5x Chinese GDP) and prompting London Telegraph columnist Ambrose Evans-Pritchard to tweet John and me a short message: “China riding tail of $24 trillion credit tiger. Tiger will eat Maoists.” And to that, I would respond that I hope the tiger doesn’t find its way to France.

Looking further into the debt problem, China is steadily incurring more and more credit for less and less growth – suggesting that the newer debt is less productive because it is being put to unproductive uses – as you can see in Chart 2 above. That explains why many analysts believe China’s official reported nonperforming loan ratio of 1% is more like 11% – or more than 20% of GDP.

Furthermore, China’s incremental capital/output ratio rose from 2.5x in 2007 to almost 5.5x in 2012. That means it takes more than twice as much debt to generate a given improvement in growth as it did before the debt binge began; and as an aside, the interest burden on China’s total debt, at 9.2%, is higher than in the US in 1929 and near the peak interest burden in 2008. Moreover, debt-service costs in China are more than double the total interest burden seen at any time in the last 100 years of US history.

China’s massive debt build-up since 2008 looks like the perfect recipe for a particularly destructive banking crisis; but as George Soros explains, “There are some eerie resemblances with the financial conditions that prevailed in the US in the years preceding the crash of 2008. But there is a significant difference, too. In the US, financial markets tend to dominate politics; in China, the state owns the banks and the bulk of the economy, and the Communist Party controls the state-owned enterprises.”

It will be a difficult balancing act, but China’s ruling elite doesn’t appear to be in denial about its debt problem, as we have come to expect from the United States and the Japan of old. In fact, it seems the new government under President Xi Jinping is intent on popping the domestic debt bubble and allowing widespread defaults rather than continuing to leverage the system into an unmanageable crisis or a Japanese-style stagnation. The trouble is, their efforts may be too little too late to manage a gradual deleveraging from a massive debt bubble. They are about to perform a dive off the high board that has never been attempted, with the whole world watching.

Among the various reforms set forth in last November’s Communist Party Third Plenum, ranging from financial liberalization to a crackdown on corruption and pollution, the greatest challenge will be gradually deleveraging the Chinese economy without throwing growth into a tailspin. Wei Yao and Claire Huang at Societe Generale argue that the Chinese government must approach the deleveraging process in three steps:

The first step is to stall credit growth – especially the growth of risky lending – so that overall leverage rises at a slower pace. In order to achieve this, Beijing has to stick to stringent monetary policy. The market has got a bitter taste of this. Since the beginning of the year, the People’s Bank of China (PBoC) and financial regulators have issued a slew of policy-tightening measures on local government off-budget borrowing, cross-border arbitrage flows, bank WMPs and the interbank bond market. 

These measures were intended to limit the supply of easy liquidity – mostly from the interbank market – for speculative uses and risky shadow bank lending. In early June, interbank liquidity conditions started to tense up as these measures took effect. The PBoC at first adopted a surprisingly tough stance and held off on liquidity injections, which resulted in unprecedented interest rates spikes. We would agree that this app roach lacks elegance and the central bank could have been more communicative, but it was a strong signal that policymakers disapproved of all the risky lending behaviour plaguing the system. This is nonetheless a difficult stance to maintain when economic growth slows, given that credit growth has been used as a policy tool by the Chinese government to stabilize short-term economic growth.

The second step is to keep rolling over (a majority of) bad debt. This may be a necessary evil. If stalling credit growth caps the upside on economic growth, rolling bad debt should limit the downside, at least in the near term. The purpose is to avoid sparking a series of corporate bankruptcies, and economic growth can also do its part in deleveraging. Particularly in the case of infrastructure debt, keeping existing projects going can help manufacturers’ supply glut from going wider, and some projects, once completed, may eventually generate cash flow.

In addition, an improving global economy is likely to invite a return of export demand.

The third step is to start NPL disposals bit by bit. Many companies in China are probably unable to even support interest payments on their debt. If the financial system were to keep all of them alive, the percentage of financial resources that goes into the efficient part of the economy would only decline. This is essentially the lesson we can learn from Japan’s lost decades – the economy struggled to grow due to the large number of zombie companies in the system. Therefore, China needs to let bad projects fail and failing companies disappear to make space for efficient ones.

(Wei Yao & Claire Huang, “Asian Themes: Deflating China’s credit bubbles.” Societe Generale; September 19, 2013)

If President Xi Jinping, his Politburo comrades, and the People’s Bank of China can work together to slow credit growth, roll over the majority of bad debts, and gradually start disposing of the worst nonperforming loans, they may have a small, but not hopeless, chance of avoiding the difficult choice between a forceful deleveraging and footing the bill to backstop defaults and/or bank failures that could pile up toward 20% of GDP. That increasingly likely scenario would seriously disrupt real GDP growth along with China’s annual budget.

Trouble is, the People’s Bank of China has allowed some pretty wicked cash crunches over the past year. Some say it was an intentional move to discipline the shadow banking system. That scenario scares the hell out of me, because that kind of behavior suggests the Chinese are playing a dangerous game – and not just with their own economy. Interbank rates do not normally bounce from 2% to 12% in a healthy economy.

In the chart below from Bloomberg, it appears that fluctuations in FX flows may explain a lot of the easing and tightening happening in the interbank market. I suspect this is a clear sign that the PBoC may already be losing control.

For all practical purposes, with China’s corporate debt above 150% and total debt above 210%, history suggests that China’s Minsky Moment is quickly approaching. Investors should prepare for the inevitable demand shocks and fall in global growth regardless of the specific outcome. The Chinese government may have the assets to backstop a truly horrific crisis and maintain slow growth in the 2-3% range; but then again, Mark Hart may have the final word.

Four years on, the denouement has clearly taken longer to arrive than Mark expected, but he is still in the market with his Corriente China Opportunities Fund. And he is still betting big against the yuan, which continues to surprise and slide.

With so much of the market expecting one-way appreciation in the RMB/USD – despite a crescendo of warnings of currency volatility from the PBoC – such moves represent a big surprise and may simply be the first steps down.

China’s government finds itself on the exact opposite side of the carry trade now,  and it appears they have a lot to gain by unwinding it – on the order of $200 billion for every 10% devaluation in the CNY/USD. It’s essentially a way to join the currency war and boost exports without appearing to circumvent the free market.

Contrary to what many onlookers believe, the People’s Bank of China and China’s top leadership are probably not willing and possibly not able to defend the currency while also supporting growth in a deleveraging economy. They will have to make a choice, and frankly, they already have an incentive to let the renminbi fall as they attempt to put the right reforms in place to support long-term growth – or face a deflationary nightmare in the uncomfortably near future.

Not many people realize that China has lost a great deal of competitiveness as its real effective exchange rate has risen in recent years.

Source: OECD

This is the same kind of dynamic that made Ireland, Spain, Greece, Italy, France, and others so uncompetitive relative to Germany in the easy-money years leading up to the euro crisis.

Source: JPMorgan, “Guide to the Markets”

American, European, and Japanese politicians will have a hard time making the case for a downward-trending RMB as long as it floats freely. And honestly, the flip side will be difficult to defend. Although many economists believe that China’s abundant reserves, near 50% of GDP, will be enough to stem the tide in the event of capital flight, I don’t believe they are looking at the right data. In light of clearly wasted spending and widespread capital misallocation, GDP is artificially inflated … not to mention that a substantial portion of Chinese reserves may have already been locked up in loans to foreign borrowers. 

M2 is a far better proxy for the capital that can rush out of an economy without warning … and Chinese M2 is now nearly twice the size of GDP. Since outstanding reserves cover less than 35% of M2, capital outflows place more pressure on the currency than most people realize. I wholeheartedly believe the renminbi will fall further over time, albeit with some serious volatility.

The Bigger They Come…
Over the last 50 years, every investment boom coupled with excessive credit growth has ended in a hard landing, from the Latin American debt crisis of the 1980s, to Japan in 1989, East Asia in 1997, and the United States after both the late-1990s internet bubble and the mid-2000s housing bubble.

The lesson is always the same, and it is hard to avoid. Economic miracles are almost always too good to be true. Broad-based, debt-fueled overinvestment (misallocation of capital) may appear to kick economic growth into overdrive for a while; but eventually disappointing returns and consequent selling lead to investment losses, defaults, and banking panics. And in the cases where foreign capital seeking strong growth in already highly valued assets drives the investment boom, the miracle often ends with capital flight and currency collapse.

John and I talk about China constantly and always reach the same conclusion. We really have no way of knowing whether the country will suffer a modest slowdown or a hard landing, but we both agree with George Soros that “The major uncertainty facing the world today is not the euro but the future direction of China.”

To be clear, China doesn’t have to experience a deep recession in order to disrupt global growth. A slowdown to 2-3% real GDP growth and a corresponding decline in China’s import demand could fire demand shocks across emerging Asian economies like India and Indonesia, commodity producers like Australia and South Africa, and even deteriorating economies in the Eurozone like France and Italy.

The investor’s dilemma is that there is really no way to know what is happening in China today, much less what will happen tomorrow. The primary data is flawed at best, manipulated at worst, and there seem to be a lot of inconsistencies when we compare official data to more concrete measures of economic activity.

Even China’s new premier, Li Keqiang, believes China’s GDP numbers are “man-made” and therefore unreliable, according to a US diplomatic cable released by WikiLeaks in 2010. For what it’s worth, that same cable suggests the premier is more interested in measurements like electricity consumption (officially expected to rise by 7% in 2014), rail cargo volumes (officially expected to rise by 2% in 2014), and bank loans (officially expected to stall in 2014) ... which are all showing potential signs of fatigue.

From an investment perspective, China’s predicament can teach us one valuable lesson. The most important risks are often the ones you cannot easily anticipate, and thorough diversification may be your only defense. As the Chinese say, “Precaution averts perils.”

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Asia’s path to prosperity and investment opportunities

Investors have been worried about the effect of a Chinese slowdown on Asian emerging markets, but the long-term growth story is still intact, according to specialist investment manager Matthews Asia.

Consumption is one of the key areas of growth. Illustrating the divergence of Asian economies and their path to prosperity, here’s an interesting chart from Matthews which shows the standard of living of various Asian countries, expressed by applying Geary-Khamis dollars — the concept of international dollars based on purchasing power parity — to today’s Japan.

For example, the living standards of North Korea and Mongolia are at around that of Japan in the 1890s — when Japan and China fought in the Sino-Japanese war and Wilhelm Rontgen discovered x-rays — while China’s is equivalent of an early 1970s Japan and Malaysia and Thailand are a step ahead at the mid-1970s.

This means a lot of countries have further to go until they reach the present economic status enjoyed by Japan, South Korea and Taiwan, giving investors huge opportunities.

“There’s a vast opportunity set for you to participate in the consumer story. Development of the services sector is a driving factor going forward,” says Lydia So, U.S.-based portfolio manager of Matthews.

She says that one chain convenience store in the Philippines — which stands at a 1950s Japan — serves 80,000 people, while in Japan there’s one for every 2,200 people — because there are many mom-and-pop stores in the Philippines, like in Japan back in those days.

So focuses on small cap stocks and her average holding period is three years. “(With small caps) you can choose a lot of companies with more focused business models… We don’t invest in a speculative manner,” she said.

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Large Jobstreet block sold

Last week, prior to the dividend cut off date, there was a single day when Jobstreet had a very large transaction. I was sort of expecting Fidelity to be selling and it was true that the large block of some 14 million shares in a day. Who has been buying is unknown as well as why Fidelity has been selling is also unknown.

The only thing that I am guessing is that since Fidelity owns a substantial block of Seek (as shown below), I would guess that it does not want to own as many stocks in Jobstreet during a period where it is critical to get shareholders approval for the deal. As it is, Seek already owns some 22.2% of Jobstreet, it does not help when Fidelity also owns a substantial block of the target. I am not sure if Fidelity is allowed to vote among the shareholders meeting although the submission papers does not mention that. Whatever is known is that for the deal to be approved, it will require 75% shareholders approval (with Seek abstain from voting). 75% is substantial.

The large chunk of Jobstreet's shares were sold at RM2.41 prior to dividend (ex-date 10 March). The parties whom bought the large block from Fidelity off market would have made a handsome gain over a short period of time if Jobstreet is worth more than RM2.60. That's how the rich makes money, I guess!

Fidelity's holding of Seek.com

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Intrinsic Value: Berkshire Shareholder Letter Highlights

According to the latest letter, Berkshire Hathaway's (BRKa) per-share book value increased to $ 134,973.

In comparison, 49 years ago -- when Warren Buffett began running Berkshire --  per-share book value stood at just $ 19 (no zeros missing here). So that's an overall gain in per-share book value of 693,518% compared to roughly 9,841% for the S&P 500 (or 19.7% annualized gain compared to 9.8% for the S&P 500 over that time).

Now, that S&P 500 performance isn't exactly shabby even if it looks unimpressive by comparison.

Changes to per-share book value compared to the S&P 500 has been the Berkshire performance measurement of choice for some time.

It's a useful measure though far from perfect as is explained on page 107 of the annual report:

"Inadequate though they are in telling the story, we give you Berkshire's book-value figures because they today serve as a rough, albeit significantly understated, tracking measure for Berkshire's intrinsic value."

Buffett explains that the gap between intrinsic value and book value has actually been increasing in recent years. In other words, increases to per-share intrinsic value is almost certainly greater than the already astonishing -- I think it's fair to say -- increases to book value over the past 49 years.

In the latest Berkshire shareholder letter (released over this past weekend), Buffett also explains -- as he has on prior occasions -- how he thinks about book value as it relates to intrinsic value:*

"What counts, of course, is per-share intrinsic value. But that's a subjective figure, and book value is useful as a rough tracking indicator."

He goes on to add...

"As I've long told you, Berkshire's intrinsic value far exceeds its book value. Moreover, the difference has widened considerably in recent years. That's why our 2012 decision to authorize the repurchase of shares at 120% of book value made sense. Purchases at that level benefit continuing shareholders because per-share intrinsic value exceeds that percentage of book value by a meaningful amount. We did not purchase shares during 2013, however, because the stock price did not descend to the 120% level. If it does, we will be aggressive. 

Charlie Munger, Berkshire's vice chairman and my partner, and I believe both Berkshire's book value and intrinsic value will outperform the S&P in years when the market is down or moderately up. We expect to fall short, though, in years when the market is strong – as we did in 2013. We have underperformed in ten of our 49 years, with all but one of our shortfalls occurring when the S&P gain exceeded 15%."

Buffett goes on to say this later in the new letter:

"As much as Charlie and I talk about intrinsic business value, we cannot tell you precisely what that number is for Berkshire shares (nor, in fact, for any other stock). In our 2010 annual report, however, we laid out the three elements – one of them qualitative – that we believe are the keys to a sensible estimate of Berkshire's intrinsic value."

He then provides an update for the two quantitative elements:

- Per-share investments: $129,253 per share

- Pre-tax earnings from businesses other than insurance and investments: $9,116 per share

"Since 1970, our per-share investments have increased at a rate of 19.3% compounded annually, and our earnings figure has grown at a 20.6% clip. It is no coincidence that the price of Berkshire stock over the 43-year period has increased at a rate very similar to that of our two measures of value. Charlie and I like to see gains in both sectors, but we will most strongly focus on building operating earnings."

Those two quantifiable elements provide a more straightforward starting point (though far from sufficient) for estimating Berkshire's per share value. Even so, no two people are likely to come up with the same estimate.

There are more messy aspects of estimating per-share intrinsic value -- and, yes, in some ways more challenging to judge though no less important -- that shouldn't be ignored. Things that are tough or impossible to quantify but of significance.

With Berkshire specifically, there's what Buffett has called the "'what-will-they-do-with-the-money' factor".
(The importance of this factor is explained on pages 109-110 of the latest annual report. It was initially covered in 2010.)

There's also the performance of Berkshire's float over time.**

Both can have an impact on value, favorable or not, that's very real.

Some might be inclined to minimally consider (if at all) what is, more or less, difficult to calculate or quantify -- and instead, in this case, maybe emphasize the two more quantitative elements -- but for many investments that's a good way to make a costly misjudgment. At times, looking at an entirely different discipline for perspective can be useful way to illustrate the point. Well, consider the following from Freeman Dyson as he writes aboutLord Kelvin's large miscalculation of the earth's age:

"Kelvin based his calculation on his belief that the mantle of the earth was solid and could transfer heat from the interior to the surface only by conduction. We now know that the mantle is partially fluid and transfers most of the heat by the far more efficient process of convection, which carries heat by a massive circulation of hot rock moving upward and cooler rock moving downward. Kelvin lacked our modern knowledge of the structure and dynamics of the earth, but he could see with his own eyes the eruptions of volcanoes bringing hot liquid from deep underground to the surface. His skill as a calculator seems to have blinded him to messy processes such as volcanic eruptions that could not be calculated."

Convection was important but not easily calculated, so Kelvin instead focused on what could be more easily calculated. Dyson points out that this led to Kelvin's estimate being short by something like 50-fold. Certainly enough to matter. The error of focusing too much what can be more easily quantified over what cannot applies to investment just as it applies to science.***

For example, if Berkshire's float remains a low cost (or, as has often been the case for Berkshire, better than free) and stable (i.e. a minimal need to post collateral especially at inopportune times/can't be called away or withdrawn when needed most) source of funds, it will have a significant positive impact on intrinsic value. Fortunately, estimating the impact float has on value isn't as difficult as estimating the earth's age. That's the good news. The bad news it's still not easy to more than roughly figure out what kind of economic value should be attached to it.

From the letter:

"If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit is earned, we enjoy the use of free money – and, better yet, get paid for holding it." 

If, instead, significant ongoing underwriting losses were to occur in the future, then Berkshire's intrinsic value would end up being much less. Buffett goes on to say that he expect Berkshire's float to be "both costless and long-enduring".

Those who are confident that Buffett is roughly right should come up with at least a somewhat different valuation than those who think he might be too optimistic about how the characteristics of Berkshire's float will change over the long run.

"The value of our float is one reason – a huge reason – why we believe Berkshire's intrinsic business value substantially exceeds its book value."

Two reasonable investors could rightly have differing views on the value of Berkshire's float. But those who think the value of float can be nailed down with some level of precision would be kidding themselves.

What's important to remember is that this cuts both ways when it comes to estimating value. The more difficult -- in some cases even nearly impossible -- to quantify but important stuff can both just as easily subtract from as add to value (and, depending on whether it subtracts or adds, lead to either errors of omission or commission).

So, when it comes to estimating value, the significance of certain elements are tough to specifically pin down beforehand. The value of float may be more easy to roughly quantify than the "'what-will-they-do-with-the-money' factor", but that's not saying much. 

Spreadsheets, no matter how complex and/or thoughtfully done, just won't provide many insights.

So, while it may not be easy to figure out the impact on value with any kind of precision, it may be possible to understand it, more or less, directionally. In other words, it's sometimes wise to admit that it's only possible to judge whether the impact is likely to be positive or negative, while maybe not knowing by just how much. Some will surely be uncomfortable with this kind of messiness but, to me, it's an inevitable part of the investment process. It just means the investor has to allow for a somewhat wider range of outcomes and pay a price that takes the low end into account.
(Others might attempt to overcome the messiness by making a complex model that's built on lots of questionable assumptions. Well, the simple and well thought out usually beats the complex. Overly complex models are a great way to create something that appears precise -- falsely so -- and, maybe, creates unwarranted overconfidence in their reliability and utility. Those who possess the ability to think critically, reduce unnecessary errors, and truly know their own limits will probably be more effective in the long run.)

That's where margin of safety comes into play. It may not be very useful to someone who is attempting to estimate the age of the earth. Yet it works just fine, at least up to a point, within an otherwise sound investment decision-making framework. An investor has the luxury of choosing to not invest at all (and moving on to something else) if they're not comfortable with not knowing the hard to quantify stuff. The key thing is to not make the equivalent of Kelvin's mistake: that is, stubbornly continuing to focus on what lends itself to calculation and ignoring what's harder to calculate but possibly, in some cases, more important. This behavior will eventually end up being expensive for those who make it a common practice.

Flexibility beats being rigid.

For investors, choosing not to invest at all works just fine; acting like Kelvin does not. There are plenty of investment alternatives so there's no need to purchase something that's not well understood (necessarily unique to each investor). There's never a good reason to do otherwise.

Those who choose to emphasize what can be quantified in lieu of what matters a whole lot more but just happens to be mostly subjective, qualitative, or difficult to calculate will likely make unnecessary mistakes; they'll also likely miss opportunities.

Of course, a focus only on Berkshire's per-share investments and pre-tax earnings (from businesses other than insurance and investments) to determine intrinsic value wouldn't exactly be the same as the mistake made by Kelvin.

The investor might just decide to view the qualitative stuff as it relates to Berkshire as upside. In other words, pay a discount to value based only on the easy to quantify stuff.

This works when confident that the qualitative stuff won't be some kind of investment wrecking ball.

So that approach might work for a Berkshire investor but, for many others, the hard to quantify but important stuff just might overwhelm everything else. For example, misjudging something like how sustainable the competitive advantage of a particular business is -- not at all an easy thing to measure but terribly important -- could end up being very costly.

The lesson of Kelvin's blunder (and similar) will remain very relevant to investment decision-making.

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