Start With the A's

How would Warren Buffett do it if we were starting all over again?

In October 1993, Adam Smith aired an interview with Buffett and it went like this:

Adam Smith: If a younger Warren Buffett were coming into the investment field today, what areas would you tell him to point himself in?

Warren Buffett: Well, if he were doing – if he were coming in and working with small sums of capital I’d tell him to do exactly what I did 40-odd years ago, which is to learn about every company in the United States that has publicly traded securities and that bank of knowledge will do him or her terrific good over time.

Smith: But there’s 27,000 public companies.

Buffett: Well, start with the A’s.

Warren Buffett -- 50% Returns

Much attention has surrounded reports that Warren Buffett said he could generate 50% returms on small sums of money. Typically, three immediate questions arise:

Did he really say that? Did he really mean it? And, how would he (or me or my favorite money manager) do it?

Looking at the record of his comments, it's pretty clear that he said it (and repeated it) and he really means it.

Buffett seems to have got the set this ball rolling in 1999. At that year's BRK shareholder meeting, he was aked:

Shareholder: Recently, at Wharton, Mr. Buffett, you talked about the problems of compounding large sums of money. You were quoted in the local paper as saying that you're confident that if you were working with a small sum closer to $1 million, you could compounded at a 50% rate. For those of us not saddled with a $100 million problem, could you talk about what types of investments you'd be looking at and where in today's market, you think significant inefficiencies exist?

Buffett: I may have been very slightly misquoted, but I certainly said something to that effect. I talked about how I polled this group of 60 or so people I get together with every couple of years as to what rate they think they can compound money at if they were investing small sums: $100,000, $1million, $100 million, $1 billion, etc. And I pointed out how the return expectations of the members of this group go very rapidly down the slope.

But it's true. I could name half a dozen people that I think can compound $1 million at 50% per year -- at least they'd have that return expectation -- if they needed it. They'd have to give that $1 million their full attention. But they couldn't compound $100 million or $1 billion at anything remotely like that rate.

There are little tiny areas, as I said, in that Adam Smith interview a few years ago, where if you start with A and you go through and look at everything -- and look for small securities in your area of competence where you can understand the business and occasionally find little arbitrage situations or little wrinkles here and there in the market -- I think working with a very small sum, there is an opportunity to earn very high returns.

But that advantage disappears very rapidly as the money compounds. As the money goes from $1 million to $10 million, I'd say it would fall off dramatically in terms of the expected return -- because you find very, very small things you're almost certain to make high returns on. But you don't find very big things in that category today.

Later, similar comments by Buffett were reported in the June 25, 1999 Business Week:

"If I was running $1 million today, or $10 million for that matter, I'd be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I've ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that."

He has repeated similar statements in recent meetings with college students, and at the 2007 annual meeting, he hit the topic again:

If I were working with a very small sum – you should hope this doesn't happen – I'd be doing almost entirely different things than I do. Your universe expands – there are thousands of times as many options if you're investing $10,000 rather than $100 billion, other than buying entire businesses. You can earn very high returns with very small amounts of money. Everyone can't do it, but if you know what you're doing, you can do it. We cannot earn phenomenal returns putting $3, $4 or $ 5 billion in a stock. It won't work – it's not even close. If Charlie and I had $500,000 or $2 million to invest, we'd find little things we could do, not all of it in stocks.

This most interesting part of the statement is the emphasis on how different his activies and opportunities would be with smaller sums of capital and therefore more opportunities: "I'd be doing almost entirely different things than I do." Not sitting on Coke, the Washington Post, AXP. Not committing new money in the past few years to BUD, WMT and JNJ.

What then would he do? Well, he's hit this theme a few times also. At the 1998 shareholder meeting he said:

There are little tiny areas, as I said, in that Adam Smith interview a few years ago, where if you start with A and you go through and look at everything -- and look for small securities in your area of competence where you can understand the business and occasionally find little arbitrage situations or little wrinkles here and there in the market -- I think working with a very small sum, there is an opportunity to earn very high returns.

What was the Adam Smith interview? It aired in October 1993, and it went like this:

Adam Smith: If a younger Warren Buffett were coming into the investment field today, what areas would you tell him to point himself in?

Warren Buffett: Well, if he were doing – if he were coming in and working with small sums of capital I’d tell him to do exactly what I did 40-odd years ago, which is to learn about every company in the United States that has publicly traded securities and that bank of knowledge will do him or her terrific good over time.

Smith: But there’s 27,000 public companies.

Buffett: Well, start with the A’s.

As he explained at the 2001 shareholder meeting:

When I started, I went through the manuals page by page. I went through 20,000 pages in the Moody’s industrial, transportation, banks and finance manuals -- twice. I actually looked at every business -- although I didn’t look very hard at some.

He told Columbia business students in 2006:

Reading has made him rich over time. He told the story of going through Moody’s annuals in 1951. “It was absolutely a question of turning pages”. On page 1433, he found Western Insurance Securities. Its earnings per share were as follows: 1949 -$21.66, 1950 - $29.09. In 1951, the low-high share price was $3 - $13. He went to a broker and read the Best’s Insurance manuals, and talked to agents – it was a perfectly fine company with nothing wrong. Ten pages later, on page 1443, he found National American Fire Insurance (“This book really got hot towards the end!”) NAFI was controlled by an Omaha guy, one of the richest men in the country, who owned many of the best run insurance companies in the country. He stashed the crown jewels of his insurance holdings in NAFI. In 1950, it earned $29.02. The share price was $27. Book value was $135. Buffett found it fascinating that this company was located several blocks from the broker where he worked. His fellow brokers were bright, rational people whose job it was to buy cheap securities, and they refused to buy NAFI, instead investing in “blue chips”.

He then took out a copy of the 2005 Korean Stock Market guide. It was more of an almanac than a brokerage report. It was sent to him for free by a broker. “If it had been $10, I wouldn’t have paid for it.” Based on the recommendation of a friend who thought South Korean stocks were cheap, Buffett spent 5-6 hours leafing through the pages and put together a $100m portfolio of 20 or so companies. Daehan Flour sold 25% of the flour in South Korea, which had a large and stable economy. It’s earnings over the last few years: 12,870 won, 18,000 won, 22,830 won. It had over 100,000 won in securities. The stock price was 38,000 won. “You have to make money buying stocks like this at 2x earnings. Brokers aren’t going to tell you about Daehan Flour.”

All this corresponds nicely with Charlie Munger's recent comments to the graduating class of USC law school:

Another thing you have to do, of course, is to have a lot of assiduity. I like that word because it means: sit down on your ass until you do it.

Harvest Natural Resources (HNR)

HNR is an oil & gas company. Its primary asset is the right to drill and sell oil and gas from fields in Venezuela.

The big picture: HNR appears to trade at a substantial discount to its intrinsic value. Current share price compares to estimated intrinsic value of $20-$25 per share. The big risk is political risk, the risk that HNR is subject to continuing expropriation through renegotiated or broken contracts with Venezuela. Given that the original contract been broken by VZ in 2006, and renegotiated in late 2006, has enough risk been removed to justify investment?

Total reserves 3P (proved, probable and possible) are worth about $23 per share. Cash on hand, net of debt, is about $3.00 per share. Thus for $7.00 per share (excluding net cash) you get reserves worth $23 per share, if HNR starts operating again.

A great Warren Buffet quote comes to mind:

I prefer businesses domiciled in the U.S. Susie and I each have one share of a stock I bought in 1955. It looked very safe at the time. It was a marvelous stock. There’s just one problem. Its property is located in Havana and Castro seized it. We can’t get title to it. It just sits there. We’ve got huge claims against the government. And it’s never going to be worth anything. I keep it round to remind me of what can happen. The rules in other countries can change overnight.

Having been warned by the master, how do we estimate intrinsic value? Two methods to start: (1) enterprise value per barrel of oil and (2) enterprise value compared to discounted value of income from reserves (ev/PV10).

Enterprise Value Per Barrel of Oil
Currently, at a $10 share price, that's equity market value of 376mn (37.55mn shares @ 10 per share) plus 98mn of debt less 213mn of cash. 376+98-213=261mn.

Reserves net to Harvest after Petrodelta agreement takes effect are:

Proved: 45mn
Probable:31mn
Possible: 74mn

Thus, you pay $5.80 per proved barrel, or $1.74 for 3P (proved, probable and possible).Leading oil & gas companies without political risk trade around $18 per proved barrel.

Since per barrel comparisons can be tricky, because different companies have different prices for oil sales price, lifting costs, etc., we should also look at ...

Discounted Value of Reserves
HNR provides an estimate of after-royalty, but before VZ tax, income, discounted at 10%. Proved $616mn Probable 317 Possible 792

Total $1,725 Subtracting a VZ tax of 50% would leave discounted net income for reserves of:

Proved $308mn, or $8.20 per share
Probable $159mn, or $4.22 per share
Possible $792mn, or $10.55 per share
For a total of $863mn, or $22.96 per share.

Out enterprise value is $261mn, or about $7.00 per share. Thus at $7 per share, HNR trades at a 70% discount to total reserves value.

Reimbursement -- Source of Additional Value?
Once the new agreement is finalized, HNR's subsidiary Petrodelta will receive reimbursement for oil and gas sales to PDVSA, to obtain the same economic result as if the conversion had been completed on April 1, 2006. Since April 1, 2006 through March 31, 2007, HNR delivered 6.7mn barrels of oil. The estimated price for reimbursement over this period is $47 per barrel.So, 6.7 x 47 = $315mn dollars.HNR also delivered 14.8bcf of gas, priced at $1.54 per mcf, for total sales of 22.79mn dollars.

So total sales are 315+23=$338mn.The 33% royalty must be deducted, so net sales are $226mn. During this period, costs have been about $46mn, most of which has already been reimbursed. Thus, during this period, the profit before tax for Petrodelta is $226mn-$46mn, or $180mn. Taxes are 50%, so net after tax profit is $90mn. HNR has an effective 32% interest, so its share of net income for this period will be about $29mn, or $0.77 per HNR share.

In theory, the value of this income should already be included in the discounted value of the reserves, which is as of April 1, 2006. Thus, to add the value of the interim net income would I think be double-counting, relative to the discounted value of the reserves. The dividend payment will no doubt be welcome, and might be a catalyst to recognizing overall value, but this should be a secondary factor to the value of obtaining final approval of the National Assembly and Chavez.

I expect Petrodelta will dividend less than 100% of net income for this period. Petrodelta will need more cash on hand to fund (1) cost of new rigs (2) increased operating expenses as operations expand and (3) initial capitalization of Petrodelta.

Proving Additional Reserves?
The estimates of recoverable reserves could increase after HNR resumes active drilling and development of the new fields obtained in the renegotiation. HNR has had a good record in the Monagas fields. In 1992 when HNR entered Monagas, proved reserves were 18mn barrels and HNR produced 124mn barrels in the following years.

No value has been included for the China WAB-21 parcel, but that's alright because it is the subject of a terratorial dispute between China and Vietnam. Thus no value will be realized until that dispute is first finished.

Bottom Line
HNR looks like a bargain. The political risk has been reduced, but not eliminated, with the renegotiation. Petrodelta has begun to secure rigs to drill, and PDVSA has appparently agreed to reimburse Petrodelta a portion of the costs if the agreement is not approved by the National Assembly. That appears to be a meaningful signal that approval is expected. A reasonable upside case is $25. A bad downside scenario would be probably produce the cash value of $3 per share. Weighing the odds, HNR seems like a good investment, the words of the master notwithstanding.