Broadening Buffett's Look Through Concept (#7)
Buffett's look-through earnings concept works in different ways, including risk management
I was in the finishing touches of putting together the June issue of Watchlist Investing (paywall), which will be released next week, when it occurred to me that Buffett’s look-through method1 can be applied in a lot of different ways.
The approach works equally as well on the balance sheet. One can take a company’s assets and liabilities, divide them by total shares outstanding, and multiply by the number of shares in a portfolio. Do this across a portfolio and you can build a little “look-through” conglomerate of your own with various “divisions” representing the different stocks you own, your proportionate share of receivables, inventories, fixed assets, debt, and so on.
As I was analyzing a microcap bank for the June issue I started thinking about look-through exposure. This bank has a meaningful amount of energy and hospitality loans concentrated in a specific geography. From an economic standpoint, is owning that bank the equivalent to owning energy/hospitality assets (proportionately), even though technically it’s a bank? Of course, there are other considerations, like risk/leverage/underwriting track record, but it’s essentially the same thing, right? As a bank owner, you’re technically a creditor, which means no big upside to each lending transaction, but the underlying economic exposure is there.
This train of thought brought to mind something Buffett once said (I cannot find this quote for the life of me) about being mindful of the ways risks aggregate. Risks can combine in ways that models can’t anticipate, and a good manager attempts to take into consideration all risk scenarios. To continue with our example, if a portfolio manager puts together a “diversified” portfolio that contains (among other investments) a bank that lends to the energy sector, an industrial supplier that makes products that go into oil drillers, and a hotel chain that operates in energy country, are those really three different businesses? Aren’t all ultimately tied to energy?
Another example from portfolio construction: Some managers feel the need to have explicit international exposure with companies domiciled in countries outside the US. Others take a look-through approach. For example, just one-third of Coca-Cola’s revenues come from North America. So is it really an American company?
Hopefully, these examples got you thinking about your portfolio, or the construction of a portfolio, in different ways. It almost always pays to go deeper, ask questions in different ways, and otherwise stress test your portfolio and your own thinking.
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As a reminder, Buffett’s look-through earnings approach as applied to Berkshire highlighted all earnings from its common stock investees. Only dividends showed up on Berkshire’s income statement; the rest were like an iceberg below the surface that would someday show up as a capital gain. Buffett reasoned that an investor in Berkshire should assess ALL earnings accruing to their benefit, both from Berkshire's 100%-owned businesses and those less than 20% (equity investments).