t’s a common and constantly asked question: “what will Warren Buffett do next?”
In the U.S., its answer has practical importance. If you’re a hedge fund or other asset manager and can read his mind, then buying what he subsequently acquires can generate considerable short-term profits. Of course, nobody can unerringly anticipate anybody’s actions. But if you’re a buy-and-hold retail investor who buys what Buffett has already bought and avoids what he avoids, you’ll probably generate reasonable long-term results.
With one exception that I’ll note below, Berkshire Hathaway has never owned significant parts of companies listed on the ASX. For Australians, this question’s relevance is therefore abstract rather than practical: if you consistently buy and hold the kinds of companies that Buffett does, even if they’re not the ones Berkshire holds, over time you’ll likely do well.
Study and apply his principles rather than ape his actions
Since the early-1990s, most of Leithner & Company’s directors have studied the philosophy and approach to investment of Buffett and his teacher and mentor, Benjamin Graham. Since 1999, it’s applied them to Australian conditions. (Our results appear on our website.)
Because we’ve mostly purchased the shares of ASX-listed entities, we’ve never purchased what Buffett has acquired. For that reason, we’ve never monitored his activities from month to month. Yet over the years, we’ve repeatedly been struck by the common themes of Berkshire’s and our holdings.
From the bubble of the mid-1990s to the early-2000s, for example, we eschewed Dot Coms – not because Buffett repeatedly stated that he didn’t understand them (we didn’t either), but because our methods of valuation didn’t enable us to assess them. For long stretches before and since the GFC, we’ve bought few or no stocks and ploughed a disproportionate (by mainstream standards) percentage of Leithner & Co.’s assets into short-term bonds, etc.
But during the GFC and the COVID-19 crisis, we bought rather than sold equities.
Today, we steer clear of anything to do with crypto-currencies – which Buffett has denounced as “rat poison squared” – and other unproven technologies, IPOs, private equity, and start-ups. We’re also sceptical of environmental, social, and corporate governance (ESG) standards (which, when applied rigidly to Berkshire’s suite of businesses, he has called “asinine”). Finally, earlier this year Berkshire accumulated the stocks of major American producers of oil and gas. Similarly, over the past couple of years, we’ve purchased the shares of major Australian producers.
So which Australian stocks would Buffett buy? The question is akin to “who’s the greatest footballer of all time?”.
People’s answers will inevitably differ. Unless Berkshire goes on a spending spree in this country, no answer can be definitive. But civil debate and fact-based disagreement can be interesting as well as instructive.
In this article, I nominate two of the companies whose shares Leithner & Company has purchased during the 2021-2022 financial year. We bought these companies’ shares not because we thought Buffett would if he shopped here, but because our application of his principles and methods led us to them. In this wire, I highlight those points that I believe Buffett would weigh disproportionately.
Quantitative versus qualitative factors
The justification of my nominations rests upon qualitative rather than quantitative criteria. In 2018, analysts at Wells Fargo published research that detailed the criteria which, they believed, guide Buffett’s search for additions to Berkshire’s portfolio. The analysts then enumerated the companies that met these criteria at that time. The criteria included:
- five-year average return on equity or return on invested capital greater than 15%;
- a debt-to-equity ratio less than or equal to 80% of the industry average;
- a five-year average pre-tax profit margin 20% higher than the industry average;
- attractive valuations (e.g., a current price-to-earnings ratio below its 10-year historical average)
- a price-to-book value below historical multiples; price-to-cashflow ratio lower than the industry average.
These criteria are sensible. But as an astute commentator on Gurufocus.com noted, “what is interesting about the list of companies (Wells Fargo’s research) ended up with is that while they might be ‘Buffett stocks’ from a quantitative point of view, almost none would realistically fit into his portfolio.”
If you apply these criteria, in other words, over time you’ll likely accumulate a portfolio of quality businesses at sensible prices – but probably nothing like the one Buffett might assemble.
“For example, the (Wells Fargo) analysts recommend Altria as a stock that the Oracle of Omaha might be interested in today.
As the largest cigarette manufacturer in the U.S. and the owner of the Marlboro brand (inside the U.S.), Buffett is never going to have an interest in this business due to the negative health impacts of tobacco. When once asked if he would be interested in owning part of RJR Nabisco, Buffett replied, “I’m wealthy enough where I don’t need to own a tobacco company and deal with the consequences of public ownership.”
Quantitative criteria such as Wells Fargo’s, as well as qualitative criteria such as the ones I describe below, led us to the companies the Leithner & Co. holds. These quantitative criteria alone are necessary but insufficient – that’s why Buffett has purchased none of the companies that Wells Fargo proposed.
Qualitative factors best explain why my two nominees are the types of companies that would interest Buffett if he shopped here. The quantitative ones are important, but the qualitative ones are determinative.
Aurizon (ASX: AZJ)
Aurizon traces its origins to Queensland’s first railways in the mid-19th century. Today, according to its website, it is “Australia’s largest rail-based transport business, with diversified, cross-commodity exposure through above- and below-rail services, and port terminals.”
On an average day, it hauls more than 700,000 tonnes of coal, iron ore, and other minerals, as well as agricultural products and general freight, across the nation. That’s more than 250 million tonnes per year.
Aurizon is the world’s biggest carrier of coal from mine to port; it’s Australia’s largest haulier of bulk and containerised freight; and it’s one of the country’s leading suppliers of rail design, engineering, construction, management and maintenance services.
Aurizon owns and operates as a government-regulated monopoly one of the world’s principal (by length and volumes carried) bulk-haulage, multi-user rail networks. Its engines, rolling stock, and associated infrastructure transport more than two-thirds of Australia’s exports of coal (which over the past few years has been the country’s second-biggest earner of export income).
It is also the principal shipper of coal to domestic power stations and the largest carrier of iron ore outside the Pilbara. Aurizon’s coal transport and infrastructure businesses, its minerals, grain, and other agricultural commodity haulage operations, and its container freight network between mainland centres make it one of the top 100 companies (by market cap) on the ASX.
Of Buffett, Monopolies, and Railways
“As a boy,” wrote Roger Lowenstein in Buffett: The Making of an American Capitalist (Random House, 1995), Warren and his best friend, Bob Russell, “would pass afternoons on the Russells’ front porch, which overlooked a busy intersection.” “All that traffic,” Bob’s mother recounted decades later the litany that Warren repeatedly uttered to her.
What a pity, reckoned the pre-adolescent billionaire on the make, that he couldn’t erect a toll booth!
According to Lowenstein, “Warren likens owning a monopoly or market-dominant (company) to owning an unregulated toll bridge. You have relative freedom to increase rates when and as much as you want.”
As a regulated monopolist, Aurizon doesn’t have that choice. It does, however, own and operate key “toll bridges” which Australia’s major exporters must traverse in order to reach their customers.
If you wish to export agricultural or mining commodities, then chances are – given its share of the market and unless you’re BHP or Rio Tinto – that you must pay a “toll” to Aurizon. It thereby possesses significant long-term strengths and opportunities of the kind that attract Buffett.
Over the past 15 years, Berkshire has invested heavily in transport and logistics. Explaining its US$44 billion purchase of Burlington Northern Santa Fe (BNSF), he said: “I just basically believe (that the U.S.) … will prosper and you’ll have more goods moving 10 and 20 and 30 years from now and the rails should benefit. It’s a bet on the country, basically.”
Exactly the same point applies today to Aurizon and Australia.
Aurizon’s “Strategy in Uncertainty”
In 2020-2021, the haulage of coal-generated ca. 80% of Aurizon’s revenues. Queensland produces much more metallurgical (coking) coal, which is used to produce steel, than thermal coal (which generates electricity); as a result, coking coal contributes two-thirds of Aurizon’s “below rail” tonnages and more than one-half of its “above rail” volumes.
What about coal’s, and particularly met coal’s future demand? Will it grow, plateau, abate or plunge? To most people, this is Aurizon’s key risk.
Indeed, many are certain that demand for coal will plunge and therefore that AZJ has no future.
By my – and, I believe, Buffett’s – way of thinking, a dispassionate response to this question draws attention to Aurizon’s strengths.
Over the past several years, its management and board have considered it in great detail. Specifically, they have modeled:
1. possible structural changes (in the form of six scenarios) of the demand for metallurgical and thermal coal upon AZJ’s cash flows during the next 20 years, and
2. the levers it possesses to mitigate downside risks. Aurizon detailed these scenarios, together with their key assumptions, in its presentation to investors on 8 June 2021. The best and worst scenarios, respectively, are:
- “Commodity Strong” assumes that (a) “climate action” (as opposed to rhetoric) doesn’t accelerate and (b) the production of steel in India rises from the current ca. 100 million tonnes (mt) per year to 280 mt by 2040. As a result, Australia’s exports of coal (by volume) increase by 25% by 2040.
- “Rapid Decarbonisation” assumes that all of the world’s coal-fired power plants –those currently in operation and under construction – are decommissioned or abandoned unfinished by 2032. As a result, Australia’s exports of coal (by volume) halve by 2040.
Under five of the six scenarios, Australia’s volume of coal exports rises to 2030. But in the decade to 2040, volumes fall under Scenarios 3-6. (For what it’s worth, I regard the “Rapid Decarbonisation” scenario as extremely implausible, and Scenarios 2-5 as unlikely but still possible.) Ultimately, it mightn’t matter greatly if they transpire.
“While volume scenarios are of great interest,” Aurizon stated, “what’s critical to analyse is how they potentially translate into cash flows.” The results of Aurizon’s modelling underscore its resilience:
Capital and cost levers are within our control and provide a platform to offset much of the impact from lower coal volumes. The scenario analysis is a good test of the resilience of Aurizon’s free cash flows. In all of the scenarios we have modeled, the modeling indicates the company can generate an average free cash flow of approximately half a billion dollars per year.
At its privatisation in 2010, Aurizon’s outlook and operations reflected what it had been for ca. 150 years: a public-sector organisation. It hadn’t yet achieved the efficiencies that distinguish a world-class provider of infrastructure, transport, and logistics services. A decade later, it has.
Over the past 10 years, it’s converted (cumulatively), more than twice as much – of each revenue dollar into EBITDA and NPAT.
Figure 1 plots its EBITDA and NPAT margins since 2010. The EBITDA margin has risen without interruption from 21% in 2010 to almost 50% in 2021. Its NPAT margin’s rise has been more erratic but its trend is also positive.
Figure 1: AZJ’s EBITDA and NPAT Margins, 2010-2021
Operating Cash Flows, Free Cash Flow, and Dividends
AZJ’s operations have become much more efficient. As a result, it’s generated rapidly rising – and now very strong – free cash flows. Operating Cash Flow – that is, receipts from customers net of payments to them – rose from $500 million in 2010 to $1.5 billion in 2015 (Figure 2). Since then, OCF has stabilised at about $1.25 billion per year.
As a consequence of its more efficient operations, capital expenditure plunged from $1.4 billion in 2010 to $400 million in 2020 (Figure 3).
Figure 2: AZJ’s OCF, FCF and Dividend Paid (Billions of $A), 2010-2021
AZJ requires much less CAPEX than it did a decade ago. As a result, in recent years it has produced healthy free cash flow. In 2010 and 2011, it hemorrhaged about $1 billion of cash per year; Free cash flows also rose from nothing to $750 million in 2017.
FCF quantifies a company’s ability to self-finance its operations. It produces a virtuous circle – the greater its quantity, the more the company can invest or pay to its shareholders as a dividend or share buyback. Accordingly, for a decade it’s paid a rising – and, given its rising FCF, sustainable – stream of dividends to its shareholders.
Figure 3: AZJ’s Capital Expenditure (Billions, Purchases Net of Disposals), 2010-2021
Insurance Australia Group (ASX: IAG)
IAG is Australia’s second-largest (by gross written premium) and New Zealand’s largest insurer and is, therefore, one of the 50 largest (by market capitalisation) ASX-listed corporations. As a general insurer, it primarily underwrites residential property and contents as well as motor vehicles; but it also covers business interruption, commercial property, corporate and directors’ liability, crops and livestock, and workers’ compensation.
It serves 8.5 million customers and operates under leading brands including NRMA, CGU, SGIC, and SGIO (in Australia) and AMI, NZI, and State (in NZ).
IAG has had a transactional relationship with Berkshire Hathaway, primarily in the area of reinsurance, since 2000; and on 16 June 2015 they announced a long-term partnership. A 10-year arrangement whereby Berkshire assumes 20% of IAG’s risk underpins it; and Berkshire’s purchase of $500m of IAG’s shares, approximately 3.7% of the total at the time, cements it.
Buffett and insurance
From the late-1960s until the mid-2000s, insurance dominated Berkshire’s operations and powered its growth. Today it remains one of its “Big Four” (the others are Berkshire Hathaway Energy, of which BRK owns 91%; Burlington Northern Santa Fe, the largest U.S. railway by freight volume; and its 5% ownership of Apple Inc.).
Well-managed insurers tend to produce attractive returns over the very long term; they can also generate appreciable losses over short periods and even over extended intervals.
As Roger Lowenstein put it, “Buffett has always been more involved in insurance than in his other entities and has always known that (it) has the potential to grow off the charts. But in no other industry has growth been accompanied by so many setbacks.”
Won’t climate change soon make Australia “uninsurable”?
It’s not just railways and major producers of oil and gas: Leithner & Co.’s portfolio’s current parallels with Berkshire’s also include insurers. We regard insurance as essential. The mainstream, on the other hand – including insurers! – increasingly regards insurers as risky.
To members of the general public, politicians, and “experts,” it’s apparently indisputable: a changing climate has caused the number and severity of natural disasters to increase. Moreover, this supposedly rising tide of devastation threatens Australians and their insurers. These claims are being repeated increasingly frequently and fervently, yet a glaring weakness accompanies them: they almost invariably lack credible – indeed, often any – supporting evidence.
In contrast, I recently analysed this country’s most authoritative source of relevant data, the Insurance Council of Australia’s Historical Catastrophe Database, and concluded:
The mainstream’s claims are baseless: in Australia since the late-1960s, natural disasters’ frequency hasn’t increased; nor has their severity.
Indeed, mega-catastrophes’ normalised costs have fallen. Bluntly, there’s no increase to cause; consequently, climate change – man-made or otherwise – can’t be causing it (for details, see “Will climate change soon make Australia ‘uninsurable’?”).
My results wouldn’t surprise Buffett. That’s because they corroborate with Australian data what he has found in American and global contexts. As the founder, head, and biggest shareholder of one of the world’s biggest insurers and reinsurers, his view should carry much weight – and unlike most experts, he has plenty of skin in the game.
In March 2014, he told CNBC:
“The effects of climate change, if any, have not affected the insurance market … The public has the impression that because there’s been so much talk about climate that events of the last ten years from an insured standpoint … have been unusual. The answer is they haven’t … I love apocalyptic predictions – they will help to increase rates.”
The Underwriting Cycle
Over very long periods, the price of insurance tends to increase at a somewhat faster pace than the CPI. Over shorter intervals, it can vary cyclically, and various factors can exacerbate this cyclicality.
The industry’s tendency to lurch between periods of high and low profit – or profit and loss – is known as the underwriting cycle. Hurricane Andrew was the costliest Atlantic hurricane up to that point. During the next few years, it provoked a four-fold rise in rates which subsequently collapsed.
Similarly, the attacks on 11 September 2001 triggered huge pay-outs but also five years of cumulatively large rises – which deflated during the decade after 2006.
In 2017, a spate of hurricanes striking the U.S. began to push global rates higher. Most recently, the fear (as opposed to the measurable consequences) of “climate change” has given insurers a heaven-sent opportunity to “justify” these increases.
Figure 4: Annualised Percentage Change of Premiums, Major Lines of Coverage in Australasia, Q4-2012 to Q1-2022
Since 2012, Marsh, a global insurance adviser, has compiled data about premia changes. It categorises them by region and line of coverage. Figure 4 plots its indexes for the Pacific (which, in effect, is Australia and New Zealand). From 2012-2015, premiums fell; in 2016, they began to rise, and their rise accelerated until late 2020.
Since then, has their rate of increase stabilised? If so, its current level compensates for rising CPI – and insurers’ investment portfolios generally benefit from rising rates of interest.
The insurance margin
The sum of an insurer’s profits from investment and insurance, expressed as a percentage of net earned premium, is its insurance margin. The higher is the margin, the bigger is the insurer’s underlying profit from underwriting.
Figure 5 plots IAG’s and QBE’s margins since 1996. From the mid-1990s until the GFC, QBE’s margin skyrocketed. Since then, it’s fallen sharply. As a result, over the past decade, IAG’s margin (average of 14.1%) has been materially higher than QBE’s (5.4%). IAG has also been less variable. QBE has always been a low-cost underwriter, but over the past decade it’s often been a mediocre one; hence it has seldom generated a healthy insurance margin.
IAG has been a better (albeit higher-cost) underwriter than QBE; accordingly, although IAG’s investment portfolio has contributed less to overall profits than QBE’s, in recent years it has nonetheless generated a higher insurance margin. That’s something that would attract Buffett.
Figure 5: IAG’s and QBE’s Insurance Margins, 1996-2021
Conclusion: You can’t buy what’s popular and do well
By standard criteria such as P/E ratio, dividend yield, etc., Aurizon and IAG are presently unpopular. That doesn’t trouble us, and it wouldn’t trouble Buffett. If anything, it reassures us; it also allows us to buy their shares at prices lower than our estimate of their value, and thereby benefit from others’ pessimism.
Investors are alive to the risk climate change is posing to the economy, but many are probably underestimating its impact on their share portfolios. I am not just talking about the obvious, like how floods and wildfires are hurting insurance shares.
If you want a current example of what happens when an ASX 200 company doesn’t have a credible plan, look at the Aurizon share price. The rail operator should be a hot share to buy in this climate. It is trading on a yield of around 10% and analysts think this is sustainable in FY22, if not beyond. Further, it owns infrastructure assets – something that investors crave.
But most brokers are not recommending the Aurizon share price as a buy because of its over-reliance on coal haulage. Until management can explain how it can reduce its exposure to fossil fuels and grow earnings, Aurizon will probably be sidelined by most investors.
That opinion is certainly widespread – but is it sensible? I strongly doubt it.
In key economic and financial respects, Aurizon and IAG resemble most of the businesses in Leithner & Company’s – and Berkshire Hathaway’s – portfolio. They are well-established and lead their industries; they provide essential goods and services; reliably generate profits and pay dividends, and possess the financial strength and managerial depth to address various “headwinds” (cyclical and possibly structural) – and maintain their strengths and pursue opportunities.
Like Berkshire, Leithner & Co. seeks to buy the securities of sound businesses (as established by our rigorous and independent research) at prices well below our conservative estimates of their values, and subsequently to sell them at prices that significantly exceed our assessment of their worth.
We buy from pessimists and sell to optimists – and in both transactions we act on our analysis and ignore others’ opinions.
Cognitively, most people can easily understand this approach. Psychologically, it’s very hard to practice – and so very few do. Many people claim that they think for themselves and, when necessary, boldly defy the crowd. In reality, they crave the warm glow of consensus and abhor the chill wind of independence.
It’s apparently “better for reputation,” as the British economist John Maynard Keynes, famously noted, “to fail conventionally than to succeed unconventionally.”
The problem, as Buffett phrased it in a much-lauded but seldom-read and thus rarely-heeded article, is that “You Pay a Very High Price in the Stock Market for a Cheery Consensus” (Forbes, 6 August 1979). Buffett recounted that whenever anything – however ephemeral – is the matter with a company, an industry the stock market, or the economy as a whole, the throng clamours that “there are just too many question marks about the near future; wouldn’t it be better to wait until things clear up a bit?”
Before reaching for that crutch, face up to two unpleasant facts: The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty is the friend of the buyer of long-term values.
Investors worthy of the name know that following the herd is eventually dangerous – and that taking one’s own counsel can generate big rewards. Many take the crowded speculative highway; few choose the investment road less travelled. It’s solitary, and often elicits criticism and even ridicule. Fortunately, its eventual financial benefit usually outweighs its transitory emotional cost.
“Most people get interested in (a company) when everyone else is,” Buffett told Newsweek (“Omaha’s Plain Dealer,” 1 April 1985). Yet “the time to get interested is when no one else is. You can’t buy what is popular and do well.”
A quarter-century later, in his Letter to Shareholders (2009) – which, significantly, appeared towards the nadir of the GFC – he elaborated:
A climate of fear is (our) best friend. Those who invest only when commentators are upbeat end up paying a heavy price. What counts in investing is what you pay for a business – through the purchase of a small piece of it in the stock market – and what that business earns in the succeeding decade or two. The obvious corollary is to be patient. You can only buy when everyone else is selling if you held your fire when everyone was buying.
“None of this means, however,” he elaborated in his Letter (1990),
…That a business is an intelligent purchase simply because it is unpopular; a (thoughtlessly) contrarian approach is just as foolish as a follow-the-crowd strategy. What’s required is thinking rather than polling. Unfortunately, Bertrand Russell’s observation about life in general applies with unusual force in the financial world: “Most men would rather die than think. Many do.”