Berkshire Hathaway recently released a snapshot of their stock investments as of Sept 30, 2022.
The company is well known as the investment
vehicle for billionaire investor Warren Buffett, two T's not one.
In this latest filing, the company's biggest new purchase - $4.1 billion, at an average
price of about $68 per share - has been our friend Taiwan Semiconductor Manufacturing Company, TSMC.
The piece of news made the rounds for a short bit.
The stock is traded in both the US and Taiwan. It jumped
about 4% in those markets the day of the announcement and a lot more thereafter.
I have been thinking about this a lot recently so I figured that I
would do a short video sharing a few thoughts about the news item.
Also by the way. I am not advising you to invest in anything. I am a YouTuber
not an investment analyst, for Pete's sake. All I own are SP500 index funds.
## Buffett or Berkshire?
The first thing to say is that it is not entirely clear who did the actual purchase.
Berkshire Hathaway employs two money managers to invest about $34 billion of
the company's money - Todd Combs and Ted Weschler.
Buffett tends to attribute smaller investments to one of those two investors and they can make
those investments without his counsel. The larger ones though are Buffett for sure.
Buffett's personal record when it comes to technology stocks is mixed.
On one hand, he has made the world's single most profitable tech stock investment.
That is, of course, a legendary $36 billion bet on Apple starting back in 2016. As of this writing,
this 5.6% stake is worth about $137 billion, for a cool $100 billion gain.
On the other hand, he also invested billions into IBM. Back in 2011 when he made the investment
on the basis of how the company acquires and keeps IT departments as its customers.
Even back then, I think that was a pretty rough view. It
took them seven years to fully exit that bet.
I reckon this TSMC bet - which is fairly large but not unprecedentedly so - was
probably initiated by one of the two secondary managers, Todd and Ted. Sorry about the clickbait.
That being said, it is Berkshire's 10th largest position across the
whole company - which probably means that Buffett knew about it and approved it.
If this bet gets larger down the line, like it did with Apple, Buffett is behind that for sure.
He also tends to go on a TV channel like CNBC to talk about the investment
so that is a dead ringer too. FYI if he does it then I'm looking forward to him
explaining High-NA EUV lithography machines and multi-patterning.
## Berkshire's Way
What follows is a gross generalization of Berkshire's compounding growth model.
Berkshire combines the use of cheap, gentle leverage with purchases of growth-oriented
stocks or businesses at a relative discount to compound shareholder value.
Let us examine the two parts of this gross generalization in further detail.
The first part is the leverage. This leverage stems not from debt taken out
or equity investments from outside parties, but instead from the premiums Berkshire
receives from its insurance customers - referred to in the industry as "float".
Premiums only need to be paid back when claims are made and accepted.
The insurance company is permitted to invest this float to generate investment income.
Per an analysis by AQR, Berkshire's annual cost of leverage has been about
1.72% - about 3% below the average US Treasury Rate during that time.
The other side of this gross generalization is the purchasing of stocks or businesses
that compound value at a rate greater than the leverage.
During the 2012 Shareholder's meeting, Buffett mentioned that he likes to buy operating
businesses with a 10x pre-tax earnings ratio. This translates to about a 10% pre-tax return.
Much like a mortgage, if you use cheap leverage to purchase an asset that compounds
in value faster than what you pay for that leverage. You gain value in the difference.
Berkshire seeks to buy a persistent 10% pre-tax earnings stream using leverage that costs 1.72%.
If you can find an opportunity like that, you go all in on it.
This is also why Berkshire Hathaway has a massive
energy and utilities division. It is picking up dollars at scale.
## Growth Value
With this now in mind, let us take a look at the stocks that Buffett buys.
He has been consistently referred to as a "value investing guru".
I think the interesting thing is that Berkshire itself does not lean towards
traditional definitions of value investing. Buffett himself might have started out that
way early in his career, but that is not how Berkshire invests today.
The traditional definition of value investment would be to invest in
companies with relatively high asset values compared to their market stock value - a
ratio referred to in the industry as having a low "price to book" ratio.
In its purest form, you don't care about the characteristics of the investment - only the
price you paid for it. Everything can be a good investment at a cheap enough price.
Buffett calls this method cigar butt investing. Per his 1989 letter:
> If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes
of the business that gives you a chance to unload at a decent profit, even though the long-term
performance of the business may be terrible. I call this the "cigar butt" approach to investing.
> A cigar butt found on the street that has only one puff left in it may not
offer much of a smoke, but the "bargain purchase" will make that puff all profit.
It works. However, Berkshire does not do this. Rather, the company puts the majority
of its portfolio on very large companies with growth potential undervalued by the market.
I mean, Buffett and his partner Charlie Munger say this explicitly. Munger explained in a recent 2021
interview that the cigar butt approach made money, but it would not fit as Berkshire got bigger.
This required a change in approach as Munger said:
> Well, it was perfectly obvious that he'd made so much money in the other technique that it
was hard for him to leave something that had worked so well. But it was not going to scale.
> So when he started looking for investment values in great businesses
that were temporarily under pressure, it changed everything for the better.
That $130 billion Apple investment is a good case study of this work in action.
## Apple
My thanks to Kalani Scarrott and his Allocators Asia newsletter for helping on this section.
When Berkshire first purchased Apple sometime in the first quarter of 2016,
the company generated about $68 billion in pre-tax earnings over the past 12 months.
The company's market cap at about that time was about $600 billion.
That calculates out to a market value to pre-tax earnings ratio
of about 8.8 times. This meets the 10x threshold that Berkshire shoots for.
At a Graham and Dodd annual breakfast, Berkshire Hathaway
managers Todd and Ted elaborated on the metrics they used to find Apple:
> Combs goes to Buffett’s house on many Saturdays to talk, and here’s a litmus test they frequently
use. Warren asks “How many names in the S&P are going to be 15x earnings in the next 12 months?
> How many are going to earn more in five years (using a 90% confidence interval),
and how many will compound at 7% (using a 50% confidence interval)?”
In an interview given after the investment was announced, Weschler explains:
> "It is cleaner to make the argument on Apple versus the past names [Nokia, Blackberry,
etc] that there is a subscription element to it”
So they clearly care about the predictability of the earnings. To them, the increasing stickiness
of the iPhone ecosystem allowed Apple to create a recurring revenue flow. This gave
them confidence that the company will retain its earning power over the next 5 years plus.
Buffett and Berkshire continued adding to their Apple stake up through the second quarter of 2018.
They would add some 75 million shares (pre-split) in the first quarter of 2018
alone. And like I said, those shares are today worth over $137 billion.
## TSMC
Now, we are finally going to talk about TSMC.
Per the 13-F SEC filing, Berkshire purchased TSMC
throughout the third quarter 2022 at an average price of $68.56.
Throughout that third quarter, TSMC’s market capitalization declined from a high of $729
billion - where it had once been the world's eighth largest company - to $353 billion.
In doing so, the company's ratios reached a very attractive level.
Over the trailing 12 months, TSMC generated about a trillion
NTD or about $32-33 billion in pre-tax earnings depending on your currency rate.
$353 billion to $32 billion gives you a market to pretax
earnings ratio of about 11 times. This is not quite 10, but it is quite close.
## Concerns
Now, Berkshire wants to have a high confidence level about the
sustainability of future growth. So we then need to review the variety
of reasons why the stock might have fallen so far. I have a few in mind.
Geopolitical tensions surrounding Taiwan and China, of course.
Larger macroeconomic concerns around the semiconductor industry as the economy grinds
slower. Various companies in technology are pulling back spend and doing layoffs.
Higher interest rates causing the relative value of stocks to fall as compared to bonds.
Increased government intervention with chip
technology export bans and plenty of chip subsidies being splashed around.
Intensifying technology competition from Samsung and Intel. And so on.
Many of these concerns are legitimate. The market is right in valuing the company far
lower than its peak earlier this year in January.
However, there are plenty of points to tick off in support of the notion that
the market put TSMC's investment value temporarily under pressure - as Munger
would put it. I have no comment on the geopolitical concerns.
First, the company's products have high margins - its gross margin in Q3 2022 was 60%.
And the company also generates a significant return on its assets and equity - above 40%.
TSMC also generates an immense amount of free cash flow, though a substantial
portion of that has to be reinvested into equipment and capital expenditure.
Second, the company has maintained growth in 2022 despite the challenging macroeconomic
conditions and an increasingly large revenue base. Based on its own projections,
TSMC is estimated to do about $76 billion in revenue in 2022.
The company reports its monthly revenues, and the latest November read shows growth
accelerating again to over 50% year over year as TSMC ships new chips for Apple devices.
Third, the company's revenue model is easy to understand.
They take orders from customers to build a factory and sell them the production.
TSMC is not going to invest in new factories unless they know the demand is there.
I mentioned this in the Newsletter but at the start of this year,
financial analyst Sebastian Hou pointed out that TSMC’s revenues
tend to be about 3 times the amount of capital expenditures in the prior year.
Now, this ratio dipped a bit this year. If TSMC hits the $76 billion revenue this year
they are predicting, then that is 2.82 times last year’s $26 billion CapEx.
In Q3 2022, TSMC revised down its full year CapEx spend to $36 billion. But even if we are to carry
over that same 2.82 ratio from 2022 that implies TSMC produces about $100 billion revenue in 2023.
The assumption thus is that TSMC grows its revenues predictably and
that capital expenditures are leading indicators of those future revenues.
Fourth, the company's technologies are difficult to switch away from.
As I mentioned in a previous video, Design-Technology Co-Optimization means
that nodes are by and large customized for the end user and its design.
Close relationships make it hard - though not impossible - for customers to onboard
a new foundry. The company has pricing power. Recently,
they raised prices on their core clients including Apple, Qualcomm and the like.
Many of the IPs that TSMC customers use are proprietary and patented.
TSMC has been in the top 10 US patent filers.
And the acceptance rate of its patents have also consistently been over 95%,
an indication of high patent quality.
And finally, the macro-trends downstream are very strong. Management consistently talks about the
technology transitions that semiconductors enable whether that be in AI, the cloud,
electric vehicles, or the like. I discuss a few of these interesting technologies in previous videos.
## Conclusion
Again, this video is not investment advice.
While there is some evidence that emulating Buffett's portfolio can
generate better-than-average returns over the long run, everybody has to invest in
the way that fits their own personal financial style and circumstance.
Are you a multi-billionaire? Are you a $600 billion corporation with a massive insurance
float and multiple extremely profitable and consistent operating businesses?
No you aren't. So why are you trying to invest like them?
With all that being said, I think there is a reason why TSMC is already Berkshire's
10th largest listed investment. It is a solid technology leader,
very transparent, and fits the company's business model.
It was also quite underpriced, with its growth potential under-appreciated in Q3
2022. The stock has bounced back quite a bit since then. Berkshire probably won’t
buy more at this higher price but let’s keep an eye on this position in the future.