June 1, 2001
by Michael Birbari
First, a bit of Berkshire Hathaway history is in order. In 1969, investment guru Warren Buffet decided to roll all of his assets into Berkshire Hathaway, an ailing textile mill, which he had been buying since 1962. Berkshire became Buffet’s sole investment vehicle, through which he would buy companies and manage his, as well as other shareholders’ assets. The book value of Berkshire shares has increased at an average annual rate of 23.6 percent (1965-2000).
For a few years now, I have been telling clients who are dental professionals that they have one of the best business models around. Great businesses are attractive entities to great investors.
We all know that one of the best investors of modern times is Warren Buffet. He has acquired some of the best business models and built them into one of the most enviable investment track records over the past 36 years. He has outperformed the S&P 500 in 32 of the 36 years. From a $12 price in 1965 to the recent close of $71,000, the performance has been sensational. Only a return in excess of 27% compounded would have surpassed this.
So, what is the connection between Buffet, Berkshire and a dental practice? Read on, you will be amazed at the concepts that can be borrowed from Buffet and utilized.
Before we do this, let’s examine the structure of Berkshire. There are essentially three compartments to the company. The first is outright ownership of several simple but very profitable business units. Buffet has built a tapestry of small and medium size private companies over the years by way of cash purchases. These companies (business units) are a highly profitable business that spins off a sizeable amount of cash each year.
As recorded in the Berkshire Hathaway 1999 Shareholders Report, the non-insurance group of business is diversified into manufacturing, retailing and services. This group had revenues of $5.9 billion and pretax of $711 million or 12% of gross revenues. This compares with pretax earnings of approximately 8% of the S&P 500.
As promised to his shareholders from 1960, Buffet states “our investments will be chosen on the basis of value, not popularity”. Berkshires non-public companies are all basically “unpopular” ones. Amongst the group are Borsheim, Buffalo News, Dexter Shoes, Executive Jet, Dairy Queen, Jordan Furniture, Kirby, Sees Candies and World Book Encyclopedia.
Now, let’s look at the typical dental practice, which grosses around $500,000, has overhead of approximately $280,000 and nets $220,000. This is a 42% pretax profit. That’s over three times the profit of Buffet’s companies. Imagine how many dental practices Buffet would buy if the Dentist could be hired as a salaried employee. Like Buffet’s business, the dental practice is a solid business with inherent value. It is not a complicated business and certainly not “popular”.
Think of it, 42% pretax margin. This is unusual in the business world. An income of $220,000 translates into after tax income of $120,000 assuming no tax planning such as RRSP’s, technical services companies or Family Trust structures.
Unfortunately, this after-tax cash flow tends to get absorbed very quickly by lifestyle conditions, namely cottages, Audi’s and expensive vacations. With discipline and a consistent and structured regular investment program, the above dentist could achieve wealth accumulation at an alarming rate. If the dentist saved $26,000 per year, it would cost $20,000 after tax (assuming max $13,500 in RRSP).
This brings us to the second element of Berkshire prowess – The annual accumulation of the after-tax earnings of the operating business. Buffet maintains a modest office and draws only $100,000 per year in wages. You see he is motivated by the capital gains on his holdings, not the annual income.
His genius or skill set is using the after tax profits to invest in private businesses while assembling a portfolio of marketable stocks and bonds. Over the years he has bought big positions in several large US firms.
Here is the Cost-to-Market Value as of September 30, 2000.
|Company||% Owned||Cost (Billion)||Market Value|
|American Express||11.3 %||$ 1.5 B||$ 9.2 B|
|Coca Cola||8.1 %||$ 1.3 B||$11.0 B|
|Gillette||9.0 %||$ 0.6 B||$ 3.0 B|
|Washington Post||18.3 %||$ 0.01 B||$ 0.9 B|
|Wells Fargo||3.6 %||$0.349 B||$2.591 B|
|$ 8.2 Billion||$37.0 Billion|
SOURCE: Fortune Magazine, February 2001
Again, how do we see the connection to the dental profession? Simple! The cash flow from the practice, after tax and living expenses, could be used to build a Buffet type portfolio. What would happen if this average dentist took $26,000 per year and invested it into a top quality portfolio of great business like the ones mentioned above or others like Microsoft, Nokia, GE, Pzifer or quality mutual funds and just kept adding to them for 30 years (age 30 to 60)?
The outcome would be “Buffet like” only if they were bought and held for the long run. Here’s the math; assuming the S&P 500 averages 14% compound over the next 30 years (as it has in the past 30 years).
$26,000 / year invested for 30 years: at 14% = $9,276,450
At a 3% rate of inflation that’s $3,821,000 in today’s dollars, which is a lot of money to produce a solid retirement.
According to Buffet, “If you expect to continue to purchase stocks throughout your lifetime, you should welcome price declines as a way to add stocks more cheaply to your portfolio. What better advice to contemplate considering the correction in stocks over the past 12 months?
If you can’t think of great businesses on your own, why not just buy Berkshire and get Buffet’s management for free.
Most of us don’t recognize the idea that we must pay ourselves first in the form of regular savings. This ensures our own financial security. The result is that we usually live up to our means and go into debt whenever we need a big-ticket item. Properly channeled annual savings can accelerate the rate of growth of net worth
Consider that Buffet manages his $35 billion empire out of a small office in Omaha (not Manhattan), drives a Buick and draws only $100,000 / year in wages. Rich people chase capital gains. Poor people chase income. Don’t spend all of your income — reinvest a healthy portion for capital gains… that’s the Buffet way.
The problem with most investors today is that they measure results over too short a time frame (a year or two). They measure results superficially, by the stocks price movement rather than the business fundamental.
Berkshire stock has been as high as $80,000 in 1998 and as low as $50,000 in 1999. It recently closed at $72,000. Judging by this many investors would have been short sighted and disqualified that performance. But by looking at the annual report one could see the build up of an army of cash and the ability to buy more stocks at bargain prices. This is exactly what Buffet is doing. In the year 2000, he bought over 8 companies such as Benjamin Moore Paints and John Manville.
On the subject of short-term stock market fluctuations Buffet states, “As far as I am concerned, the stock market doesn’t exist. It is there only as a reference to see if anybody is offering to do anything foolish.”
So use that great cash flow from dentistry to build a solid portfolio. Live below your means by exercising discipline in lifestyle choices and most of all ignore the stock market and take a long-term view. The results will be “Buffet like.” DPM
Michael Birbari is Director and Senior Investment Advisor at Dundee Securities Corporation. Michael is committed to providing unparalleled levels of service to the dental community.