Case Study: Michael Burry – Caterpillar Inc.

20) Michael Burry 18052016.jpg

By now, every investor worth his salt knows who’s Michael Burry. Made famous by a best selling book and a movie, he’s the guy who foresaw the GFC and profited very handsomely from it.

In the midst of doing so, he had to stare down investors who wanted to bail out after disagreeing with him, as well as multiple lawsuits. It sure takes guts and an iron-clad conviction to be able to do this.

This is the rarest of all traits, similar to what Ackman displayed in his successful shorting of MBIA before it collapsed. How does one stand firm, despite everyone saying something to the contrary, and stay firm for MANY YEARS at a stretch? Let’s not forget that no matter how you structure your shorts, there’s always a running cost to maintain a short position (Please let me know if there’s some way to short without having a running cost to do so), so time is not really on your side.

In this regard, when you have a short position, it’s not enough to be right. You gotta get the time frame approximately right too. You have to get both the investment thesis, AND the timing of the investment right. As they say, the markets can stay irrational than you can stay solvent.

Anyway, I was studying several of his investing theses. This was many years ago, before he became famous. Fortunately, he was active in investing forums and boards, and contributed many of his ideas then. I thought one such post that he made was very reflective of the thought process and decisions I personally face when evaluating an investing opportunity.

Below is what Burry wrote:

21) Caterpillar Inc Logo 18052016.png

Journal: August 3, 2000
•Buy 200 shares of Caterpillar (CAT) at the open.

“This cool Cat is one hot stock. Today, let’s go with two ideas, on the surface terribly divergent in character. The first is Catepillar (CAT), which is bouncing along lows. Whenever the stock of a company this significant starts to reel, I take notice. Everyone knows that domestic construction is slowing down. I don’t care.

Why? Let me explain. Let’s pose that a hypothetical company will grow 15% for 10 years and 5% for the remaining life of the company. If the cost of capital for the company in the long term is higher than 5%, then the life of the company is finite and a present “intrinsic value” of the company may be approximated.

But let’s say the cost of capital averages 9% a year. Starting with trailing one year earnings of $275, the sum present value of earnings over 10 years will be $3,731. If the cost of capital during the remainder of the company’s life stays at 9%, then the present value of the rest of the company’s earnings from 10 years until its demise is $12,324.

What should strike the intelligent investor is that 76.8% of the true intrinsic value of the company today is in the company’s earnings after 10 years from now. To look at it another way, just 5.7% of the company’s intrinsic value is represented by its earnings over the next three years. This of course implies that the company must continue to operate for a very long time, facing many obstacles as its industry matures.

Caterpillar can do this. Let’s take a cue from the latest conference call. When people in the know think of quality electric power for the internet, they think of Caterpillar. Huh? Yes, Caterpillar makes electricity generators that generate so called quality power. There are lots of uses for power that’s uninterruptible, continuous and free of noise, but some of the largest and fastest growing are in telecommunications and the Internet.

Caterpillar is the No.1 provider of this sort of power, and the market is growing explosively. In fact, Caterpillar’s quality power generator sales had been growing at 20% compounded over the last five years, but are up a whopping 75% in the first six months of 2000 alone. Caterpillar expects revenue from this aspect of its business to triple to $6 billion, or 20% of sales, within 4½ years. “This is our kind of game,” the company says.

General sentiment around Caterpillar is heavily influenced by the status of the domestic construction industry. But while domestic homebuilding is indeed stumbling, we’re talking about less than 10% of Caterpillar’s sales. Caterpillar is quite diverse, and many product lines and geographic areas are not peaking at all. In particular, the outlook for oil, gas, and mining products is bright. In fact, Caterpillar’s business peaked in late 1997/early 1998 and now appears to be on a road to recovery. The market has not digested this yet.

The balance sheet is also stronger than it appears. Caterpillar is another industrial cyclical with an internal finance company. I don’t count the financial services debt, as I explained in my Aug.1 journal entry. Hence, long term debt dives from $11 billion to $3 billion, and the long term debt/equity dives from 200% to just 55%.

The enterprise therefore goes for a rough 11 times free cash flow. Cash return on capital adjusted for the impact of the financial operations reaches above 15% over its past cycles, with return on equity averaging 27% over the last 10 years. Also, management is by nature conservative. Keep that in mind when evaluating its comments on the potential of the power generation business.

The main risk is that, in the short run, investors may take this Cat out back and shoot it if interest rates continue up. I’m buying 200 shares here along the lows.”

So how did this particular investment perform for Mr Burry?

22) Catepillar Inc share price 19052016

The chart says it all.

While I do not know exactly when he exited this position, it’s safe to say that this was a pretty successful investment, whichever way you look at it.

My Thoughts

Mr Burry was using the discounted cashflow (DCF) model to work out the amount of free cashflow he expects the business to generate throughout the life of the business. I worked out the figures based on what he wrote and they all roughly check out.

Ironically, the DCF data should actually discourage him from making the investment. 76.8% of the true intrinsic value of the company would only be generated after 10 years from the point when he did the analysis. Just 5.7% of the intrinsic value would be generated within 3 years at the time of his writing.

Of course, he subsequently substantiated why he made the investment by doing an analysis of the macro situation of the industry, CAT’s ability to thrive in the industry long term, as well as the current balance sheet of the company. The DCF data, although negative from the point of view of an analyst trying to determine whether to invest or not, was actually used by him to determine how long it takes for the company to earn back the present value of his investment, in future. He then concluded that it takes a pretty long time, but CAT is able to “continue to operate for a very long time, facing many obstacles as its industry matures”

This is what I personally face when evaluating potential investments. Another person running through this same data, may interpret the CF from the DCF model as highly unfavorable, and decline to invest. Afterall, if you’d imagine, the climate at that point of time was bearish on building equipment suppliers like CAT. Add the negativity from the DCF data, it is hard to imagine ignoring these facts and making the investment.

The difficulty is not in finding or analysing the data, but interpreting the data accurately and executing to benefit from this particular interpretation

I mentioned this in an earlier post about LTC Corporation (Part I and II). Most investments are not outright clear cut. I suppose if there is one such investment where all data and your analysis is favorable, that’d be a very strong conviction buy/sell.

In most instances though, some data is negative, whereas others is positive. The key question is how do we then decide that this negative data is not that negative, or this positive data is actually more positive than the market deems it to be. That’s the difficulty. When people talk about investing as being both an art and a science….. This aspect is surely the art part.

A true value investor, pays utmost attention to macro factors

Mr Burry is certainly a value investor. His influences are similar to WB’s, and he has cited WB on several occasions. Still, he develops his own style. For eg. he partially disagrees with WB’s buy and hold forever strategy.

In a different post, he said that WB has to do this simply because of the size of the capital he manages. He needs to find big opportunities that involve large capital investments. He needs to think in terms of many years, decades even. In WB’s initial years, his investments were considerably shorter term in nature, and he has even been an activist investor before despite his current criticisms of such hedge funds. By following him blindly, investors dealing with much smaller capital are losing a very important edge they’d otherwise have.

As one can see in his above analysis, Mr Burry does pay attention to the macro factors of the industry, and relates the company’s financials to the industry.

For cyclical companies, look at long term data. Think in decades, not years

Mr Burry analysed long term data. Not 3 yrs, not 5 yrs, but at least 10 yrs. For cyclical companies, looking at short to even mid term data runs the risk of looking at a picture through a pinhole – you just cant get a view of the whole picture.

No catalyst is needed if the company is strongly undervalued

As seen on the chart above, Mr Burry pretty much caught the bottom. Not long after his investment, the share price started rising strong. There wasn’t any particular stimulus to trigger the rise. Or rather, there could have been, but none of the stimulus would’ve been predictable at the point of the investment. In his words “Specific, known catalysts are not necessary. Sheer, outrageous value is enough.”

 

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10 comments

  1. Hi,

    You wrote:

    “Ironically, the DCF data should actually discourage him from making the investment. 76.8% of the true intrinsic value of the company would only be generated after 10 years from the point when he did the analysis. Just 5.7% of the intrinsic value would be generated within 3 years at the time of his writing.”

    This is wrong IMO. DCF is value discounted into present so Burry shouldn’t be discouraged at all! This is the whole point of discounting.

    Bart

    Like

    1. Hi Bart
      Thank you for your comment
      I wrote this post 2 years ago, and really had to go back to re read to understand what you’re talking about.

      Again, just looking at the DCF data alone, it SHOULD discourage him from making the investment. Yes, DCF is indeed discounting future cashflows to present value, but as per the figures presented by Burry himself, after 10 years, only 76.8% of the intrinsic value would be accounted for by the CFs, and that’s already discounted to present value.
      And after the investment is made, only 5.7% would be generated from CFs within 3 years.
      Surely these figures are not indicative of a fine investment (by itself)
      In other words, even after discounting the future CFs to present value, you’d be expecting the CFs generated by the business to return only 76.8% of the calculated value, after 10 years…

      In fact, if you read carefully his journal notes, he himself was trying to say that the numbers itself, does not warrant an investment.
      I quote: “This of course implies that the company must continue to operate for a very long time, facing many obstacles as its industry matures.”
      He was optimistic about the company because of other factors, as I mentioned in the post. (for eg. the balance sheet is much stronger than it looks)

      Regards
      TTI

      Like

      1. Hi TTI, thanks for reply. I know this post is very old but I believe the knowledge is not getting old and it is always good to share experiences :-)

        I still don’t get your point but please me share my understanding of Burry’s analysis, step by step. I think the key paragraph here is:

        “What should strike the intelligent investor is that 76.8% of the true intrinsic value of the company today is in the company’s earnings after 10 years from now. To look at it another way, just 5.7% of the company’s intrinsic value is represented by its earnings over the next three years. This of course implies that the company must continue to operate for a very long time, facing many obstacles as its industry matures.”

        Burry indeed used DCF model and assumed 15% growth rate in 10 years and 5% later. And discounting of the future flows gave him current intrinsic value of the company. Now, 76.8% of this current intrinsic value came from flows after 10 years from the present (“76.8% of the true intrinsic value of the company today is in the company’s earnings after 10 years from now”) while just 5.7% of the company’s current intrinsic value is represented by short-term earnings (“just 5.7% of the company’s intrinsic value is represented by its earnings over the next three years.”). He don’t need to wait for any intrinsic value, the whole intrinsic value from all future flows is already there. And a big chunk of this value came from the years with slow growth.

        There is also an important sentence: “This of course implies that the company must continue to operate for a very long time, facing many obstacles as its industry matures.”. It is a question whether such long-term (10+ years) DCF model is valid for this company. If the company had no future or was doomed the model had no validity.. But he later confirms that he believes in Caterpillar and that the company can operate for extended periods of time (in other words: he can discount cash flows from many, many years ahead).

        The point of his analysis is to show that investors look in short-term and discount flows only from early years with strong growth (in this case 15%). He tries to convince other that you don’t need to worry if the industry slows down because the slower growth in later years gives enormous intrinsic value when discounted.

        Bart

        Like

        1. Hi Bart
          It’s interesting cos we both understand DCF but come up with different interpretations.

          You said
          “He don’t need to wait for any intrinsic value, the whole intrinsic value from all future flows is already there. And a big chunk of this value came from the years with slow growth.”

          I don’t quite understand that statement.
          What do you mean by he “doesn’t need to wait for any intrinsic value”?
          Perhaps let me put some numbers to it so that its clearer.
          Imagine this business’ intrinsic value based on the discounted future CFs to eternity is $1mil.
          And someone comes along and pays fair value $1mil for the business.
          Every year that the company operates, it generates a certain CF for the new owner of the business. So if the business generates $100k in FCF every year, the owner has to wait 10 years before the business generates $1mil.
          Isn’t it?
          So I don’t understand what you mean by “he don’t need to wait for any intrinsic value”

          Or let me put it another way:
          Imagine I come to you with a deal now.
          If you’d give me $1mil right now, I’d pay you back a certain sum every year, and 10 years from now, I’d have paid you $768,000, of which, $57,000 is paid in the 1st 3 years.
          That is essentially what the DCF model has worked out right?
          This doesn’t sound like a very good deal and I reckon you wouldn’t take this deal.
          And that’s what I meant when I said that the data should discourage someone from making the investment.

          Now, this is slightly different from the scenario with Caterpillar though. Cos in Burry’s case study there’s the all important price.
          So the scenario could be more like: what if you were committed to a $1mil bond with me, and I’d pay you back a certain sum every year, and 10 years from now, I’d have paid you $768,000, of which, $57,000 is paid in the 1st 3 years, and guess what? This price of this “bond” is $100,000 right now.
          Now, that is a good deal isn’t it?
          Cos the price is very much lower than the intrinsic value of all future CFs calculated from DCF.
          So we have to consider the price we are paying, for the intrinsic value calculated by the DCF model.

          I’m just saying that putting aside the price of the Caterpillar shares Burry would’ve paid for, looking at the DCF numbers alone, it doesn’t immediately look very enticing.

          As for your other comments about Caterpillar being durable enough etc, there’s no debate about that. All that is self explanatory and easy to understand from the passage above.

          Lastly, let me just highlight that 1 more sentence right after the paragraph that you have highlighted.
          Burry wrote:
          “Caterpillar can do this.”
          Doesn’t this by itself, indicate that the DCF data itself isn’t favorable AT 1ST GLANCE?
          So in summary, my interpretation is this:
          Basically, he’s saying that anyone ponying up $$$ to buy the business’ future CFs discounted to current values, would receive only 5.7% of the CFs in the 1st 3 years, so the business has to hang ard long enough. (that certainly doesn’t look very attractive) But he thinks “Caterpillar can do this”, for the reasons stated below that i.e. BS stronger than it looks, power generator sales growing blah blah blah.

          Would be glad to hear your thoughts on this.

          Cheers
          TTI

          Like

  2. Hi TTI,

    Indeed, it seems that we are looking at this problem from two different sides :-) But the comment from Burry “Everyone knows that domestic construction is slowing down. I don’t care.” and the fact that I was able to reproduce in a spreadsheet the exact numbers provided by him in 3rd paragraph convice me that my interpretation is a bit closer.

    Let me present the calculations (you can easily reproduce it in the excel too).

    Assume that a company (let say Caterpillar) will have 200m USD of income for the fiscal year 1. Then assume that the growth rate of this company is 30% per year for 5 years so at the end of 2nd year the income will be 260m (200m * 1.3), 3rd year 388 (260m * 1.3).. and so on. After 5th year you assume that the growth will dramatically slow down to only 2% annualy. So the income for 6th year will be income for 5th year of 571m times 1.02.. etc. After 15th year the company will vanish.

    Now you can discount all the income flows using cost of capital of let say 9% (the number used by Burry). You should get present value of the flows equal to around 3,970m USD. And you know what? Only 33% of this value came from first 5th years of the highest, extraordinary growth. The remaining 67% came from the years 6-15 when the growth was only 2% a year.

    This is why he doesn’t care when someone says that the industry is slowing down. If the company is going to have even a very short period of good growth and then stabilize but can endure this no-growth period for some time then the current intrinsic value can be huge vs current market price.

    And he buys current (discounted) intrinsic value for current market price. If the intrinsic value > market price its a buy signal. If the company was short lived his valuation would not exceed market price. But he belived CAT was strong enought to survive for a long time.

    Btw, This argument I don’t get:
    “Basically, he’s saying that anyone ponying up $$$ to buy the business’ future CFs discounted to current values, would receive only 5.7% of the CFs in the 1st 3 years, so the business has to hang ard long enough. (that certainly doesn’t look very attractive)”

    I’ll give you 10k now for a 1 million USD 10 years from now. I don’t care if I receive any CF in 1-3 years from you! I got a good deal and I won’t sell it to anyone for even 30k.

    Bart

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    1. Not sure what we can accomplish here by going round and round, as I really think it’s a matter of interpretation. Thanks for your figures and your offer of your spreadsheet, but I think we are all consistent regarding the figures, hence the interpretation part.
      Let me just quote you and reply specifically to those portions.

      “So the income for 6th year will be income for 5th year of 571m times 1.02.. etc. After 15th year the company will vanish.”

      Stuff like this make me a bit confused. Why would the company “vanish” after the 15th year? Do you mean the earnings growth will vanish?

      “Now you can discount all the income flows using cost of capital of let say 9% (the number used by Burry). You should get present value of the flows equal to around 3,970m USD. And you know what? Only 33% of this value came from first 5th years of the highest, extraordinary growth. The remaining 67% came from the years 6-15 when the growth was only 2% a year”

      Exactly. This is a similar scenario to what Burry was describing. So we’re on the same page here.
      But why are these numbers good?
      Getting 33% of the IV in 5 years, and only getting the remaining 2/3s a long way out…
      if I could be the devils’ advocate and swap it around and compare it to another business whereby you’d get 2/3s of the CFs in 5 years and the remainder a long way out to eternity….. isn’t that better?
      Again, I actually do get your point. Like I said, it’s a matter of interpretation.
      My statement that “the numbers itself should actually discourage an investment” is generic. Not specific to caterpillar.

      “This is why he doesn’t care when someone says that the industry is slowing down. If the company is going to have even a very short period of good growth and then stabilize but can endure this no-growth period for some time then the current intrinsic value can be huge vs current market price.”

      Yes yes, we’ve already established earlier.

      “Btw, This argument I don’t get:
      “Basically, he’s saying that anyone ponying up $$$ to buy the business’ future CFs discounted to current values, would receive only 5.7% of the CFs in the 1st 3 years, so the business has to hang ard long enough. (that certainly doesn’t look very attractive)”

      I’ll give you 10k now for a 1 million USD 10 years from now. I don’t care if I receive any CF in 1-3 years from you! I got a good deal and I won’t sell it to anyone for even 30k.”

      Ah yes. If you read my earlier reply, I specifically said this scenario is different in the sense that there’s the all important PRICE.
      To illustrate, how about if you’d give me 1million USD right now, and I’d give you CFs amounting to 1/3 of this 1million USD in the 1st 3 years, and the remainder iin the 6-15th years?
      The 1mil USD is the price. Vs the 10k price that you mentioned.
      Like I said, my comment is regarding the data, not taking into consideration the price that he’d be paying for this CFs.

      I think we’re basically saying the same thing tbh. But since you added in numbers in your example, I’d quote you
      “Now you can discount all the income flows using cost of capital of let say 9% (the number used by Burry). You should get present value of the flows equal to around 3,970m USD. And you know what? Only 33% of this value came from first 5th years of the highest, extraordinary growth. The remaining 67% came from the years 6-15 when the growth was only 2% a year.”

      So…
      would you pay 3,970m USD to own this company in its entirety right now, and be willing to accept a return of 33% of the value in the first 5 years and the remaining 67% after 10 years?

      Cheers
      TTI

      Like

      1. “Getting 33% of the IV in 5 years, and only getting the remaining 2/3s a long way out…
        if I could be the devils’ advocate and swap it around and compare it to another business whereby you’d get 2/3s of the CFs in 5 years and the remainder a long way out to eternity….. isn’t that better?”

        Oh dear, of course it is better, but you would get higher present intrinsic value after doing discounted cash flow calculation.

        “would you pay 3,970m USD to own this company in its entirety right now, and be willing to accept a return of 33% of the value in the first 5 years and the remaining 67% after 10 years?”

        I’m not paying 3,970m USD to get the same amount across 15 years. I’m paying 3,970m to get over 8,188m across 15 years. This way I’m getting 9% annual profit for 15 years on my 3970m investment. So I’ll earn 8188 – 3970 = 4,218m but a big chunk of this amount will come after 5th year.

        It doesn’t mean i should feel discouraged. Because I can take mu profits from first 1-3 years and then sold this cash flow to someone else.

        Like

  3. Btw if you are interested I can share with you the spreadsheet with my calculations which give results exactly the same as Burry’s.

    Like

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