Monday, May 12, 2008

When to sell? Lessons from Buffet, Part I

I am going to pick a company that Buffet bought and sold. He bought Petrochina for about $ 500 million or 1.3% ownerships between 2002 and 2003. It is very rare that Warren Buffet disclosed how much a company worth - a golden opportunity to learn something from him on how to value a business. The valuation method was quite simple, he said he can calculates at the back of an envelope, is it so?

In 2002, the owner's equity was about RMB 316 mln which was quite closed to about US $ 35 to US 37 billion. That was what the market valued the company (It is very rare that market capitalization is almost equal to owner's equity). Buffet and Charlie felt that the company worth close to about US $ 100 billion. How did he arrive at US $ 100 billion? Why didn't others see it as US $ 100 billion, selling for about 63% discount? The answer? He sees things 10 years ahead vs. analysts project 1-2 years ahead.

Valuing a cyclical commodity stock can be difficult. If we were to value based on ROE of 15% for straight 10 years, the company worth about US $ 165 Billion. I supposed he discounted ROE to around 10-11% to get around US $ 100 Billion, to give himself a huge margin of safety.

He sold down his holdings between July - September 2007 for $ 4 billion, nice 600% or $ 3.5 billion profit. I wish I can do that. Some speculated it was due to moral reasons. PetroChina is doing business in Sudan which is well known for violations of human rights.

Looking at the chart in retrospective, I agree with him, it was purely based on fundamentals. You can see that Shanghai Composite Index already peaked around that same time, the bubble was waiting to burst. However, the price of PetroChina continued to climb(he said he left a lot of money on the table), the stock just way too popular and overtook Exxon Mobil as the largest capitalized stock in the world with about US $ 400 - $ 500 billion. Well, the party did end, some people committed suicides and some jumped out of windows. PetroChina peaked out in October and fell almost 40% from the top.

His original value assessment of PetroChina was $ 100 billion, he did not sell a stock simply because it had reached its fair value. He sold it when it was really expensive and stretching it too far when market capitalization reached $ 275 billion based on crude oil at US $ 75 per barrel and increased oil reserves. I speculated he considered overall sentiments of China market reached almost triple digit PE. Things do not seem to make sense when an economy of China is 4 times smaller than the US(though China is growing at 8-9% a year), how could you have a company with the largest capitalization in the world?

The more I'm researching about Buffet, the more I'm amazed with his business acumen's, valuation skills, common sense, crowd sentiments reading and almost perfect timing to enter and exit. He also tries not to leave too much money on the table but nobody is perfect.

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