Is Buffett Aiming at Kellogg?

A great and well-acknowledged sport is trying to spot Buffett’s next publicly traded, outright acquisition— the next target of his famed “elephant gun.” Most people do it in hopes of a quick profit on the news. This reasoning seems to be fatally flawed. The chance of finding the one company that the Oracle of Omaha targets is the worst sort of needle-in-haystack stuff.

As an exercise in finding wonderful companies at fair prices, however, it works just fine. By trying to guess what’s next for Buffett, you have to enter his mind—and all of us can profit by being in his mind (and exiting our own) from time to time. To the extent it’s possible, entering Buffett’s mind requires not just a cognitive tilt but one of temperament. We have to slow down, think more, trade less, and take a deep breath.

I’ll be unlikely to find the company Buffett will buy; just as good, though, is the company he would buy.

A flotsam of rumors point recently to Kellogg’s (K) as a potential acquisition. Putting aside whether he will buy it and concentrating instead on whether he would buy it, it could be worthwhile to give K a look; given the gossip and options activity, its price has shot up recently. Yet another reason not to try to buy the picks that inhabit conventional opinion: they carry a “Buffett premium” that will surely evaporate if he doesn't bite.

Just for the fun of it, I’d like to look at K and see if we can see the company through the eyes of Warren Buffett. Explaining his Coca-Cola purchase, he said: “It’s like when you marry a girl. Is it her eyes? Her personality? It’s a whole bunch of things you can’t separate.” So, is Tony the Tiger Buffett’s type?

A Trefis Interactive Portfolio Report

May 2014

James Berman

James Berman, the president and founder of JBGlobal.com LLC, a registered investment advisory firm (SEC registered), specializes in asset management for high-net-worth indi-

viduals and trusts. Mr. Berman is a faculty member in the Finance Department of NYU SCPS. He has appeared on CNBC and the Fox Business Channel and has been quoted and

published in a variety of publications, including Barron's, Fortune, Bloomberg, The Huffington Post and CNN Money. Mr. Berman holds a B.A., Magna Cum Laude, Phi Beta Kappa,

in English & American Literature from Harvard and a J.D. from Harvard Law School.

CONTENTS

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THE BERMAN VALUE FOLIO

Is Buffett Aiming at Kellogg? 1

China Mobile: Just My Type 4

Company Highlights 5

Alcoa 5

United Technologies 6

Apple 7

Pfizer 8

The Berman Value Folio 9

Kellogg is a company with a long, successful and storied past. Now that is certainly Buffett’s type. The company was founded in 1906 by Will Keith Kellogg. Kellogg and his brother had been experimenting with different grains at the Battle Creek Sanitarium—exploring vegetarian meal options based on Seventh-day Adventist doctrine—when they came up with Corn Flakes. This most successful of products was discovered by accident: they left some cooked wheat on the table and came back to find it stale. Not ones to waste, they ran it through rollers, intending to make sheets but ended up with flakes. They played around with other grains and the rest is cereal history.

Kellogg appears to share many of the attributes that Buffett finds so arrestingly attractive:

Established brands that act as competitive

moats to protect profits: Frosted Flakes, Fruit Loops, Corn Flakes and Special K are all iconic franchises

A simple to understand business: it’s hard to get

simpler than breakfast cereal

Good returns on invested capital. K has averaged 12% over the past decade. But Buffett usually likes higher: Heinz’s was 13% and that was low for him. He targets 15%.

The Berman Value Folio A Trefis Interactive Portfolio Report 2

The Trefis Dow

Ticker

Trefis

Market Price Price

AXP 78.97 87.13

BA 135 131

CAT 97.56 103

CSCO 25.74 23.5

CVX 122 125

DD 74.56 67.34

DIS 80.03 79.52

GE 26.2 26.42

GS 180 160

HD 81.48 78.52

IBM 227 192

INTC 26.67 26.75

JNJ 90.86 100

JPM 62.07 56.05

KO 40.89 40.73

MCD 98.94 99.13

MMM 140 138

MRK 52.84 57.5

MSFT 41.21 39.69

NKE 67.49 74.1

PFE 33.56 30.92

PG 70.29 80.36

T 37.5 34.92

TRV 97.7 88.13

UNH 73.59 75.33

UTX 121 120

V 197 209

VZ 52.86 47.43

WMT 79.3 78.04

XOM 92.33 100

DOW

Trefis Market

Price Price

16,731 16,495

1% Undervaluation

Kellogg: Valuation

The Berman Value Folio A Trefis Interactive Portfolio Report

Trefis doesn’t cover Kellogg so we have to do our own discounted cash flow valuation. K generated $1.17 billion in free cash flow over the past year, a level which looks pretty normalized, just what you’d expect in the stable cereal business. Earnings per share has grown at 4.32% over the decade, a level I would not expect K to exceed over the next ten. To be conservative, I’ll apply a 3% prospective growth rate. K is leveraged, with assets more than four times equity. Aside from that, it’s as low risk as you can imagine. The company’s cost of capital cannot be higher than 8%. It could even be less, but 8% is as low as I go in a model for any publicly traded stock.

For the terminal value, I’ve used a 2% growth rate. The present value of expected free cash flows is $28.7 billion. After subtracting approximately $7 billion in K’s net debt, we’re left with a $21.6 billion intrinsic value for the equity. On a per share basis, that’s $59. Kellogg currently trades at $66 which looks like a significant premium to true value.

On these grounds alone, assuming he entered the same assumptions, Buffett would decline. With lesser returns on invested capital than he normally seeks and a moat that, while fortified, is subject to intense competition, K might just not be for him. This appears to be more of a good company trading at a mildly inflated price—less than a wonderful company trading at a fair price.

Buffett’s universe of investable companies (those that would move the needle on returns) continues to drop as his equity base grows monstrously, one factor that has led him to lower his standards. This is the one factor that could lead him to buy a company like Kellogg, which is more a double or a triple than a home run. But an equity base the size of Mt. Everest is a quality problem—and one we don’t have, probably our only advantage over the Oracle of Omaha! So I personally wouldn’t choose K.

My final qualitative nix on this stock is this: for all its iconic brands, Kellogg just isn’t Heinz. It lacks that clear dominance, contending instead with General Mills’ Cheerios and Post’s Honey Bunches of Oats. This is far less the quasi-monopoly of ketchup. Cereal is beset by all manner of competition from private label brands, a trend that has not yet hit condiments the same way.

Kellogg just isn’t Heinz and Tony the Tiger (apologies to Tony) just isn’t our type.

3

China Mobile: Just My Type

The Berman Value Folio A Trefis Interactive Portfolio Report

One company that is my type is China Mobile (CHL), the largest cell phone provider in the world: 770 million customers. Now that’s scale! I’ve owned CHL for over a decade in my fund. I once owned a large position which got periodically trimmed as CHL increased in value. For some reason I held onto a tiny stub even once it was clear CHL was overvalued. I think I just liked keeping my hand in the cookie jar of 1.3 billion potential Chinese cell phone customers. It was a greedy, dumb move. CHL has gotten whacked over the past three years, underperform-ing the S&P 500 by 10% annualized. I should have sold the whole thing.

The terrible returns have allowed the precious fundamentals to catch up with the price and now CHL is undervalued again:

There are many legitimate problems with CHL. State ownership makes the company a pawn of the Chinese government with respect to policy decisions: CHL was forced to the less efficient TD-SCDMA standard for their 3G network. Does that sound rational? In addition, CHL is re-quired to share its cell infrastructure with other carriers.

But CHL has a fortress-like balance sheet and gushes free cash flow. Just the dividend yield is over 4%. The free cash flow yield is 10%, a figure you used to see a lot in 2009 but less so now. Trefis pegs fair value at $53 (based on conservative assumptions) which I think is about right.

Between that measure of undervaluation, a 3% FCF growth rate and a 4% yield, I think CHL can easily deliver double-digit returns. I’m buying it in this issue.

4

COMPANY HIGHLIGHTS

Alcoa

I just wrote about Alcoa (AA) last week after a favorable court decision firmed up aluminum prices. Now AA has gotten ahead of itself, up 12% in the last month alone and up 27% year-to-date. Time to leave behind this commodity-based, poor-returns-on-capital stock. Like Dow Chemical (DOW), it was a “cyclical” purchase more than a long-term hold. That hand has played itself out. The market is starting to recognize recovery in many industrial and metals stocks. That’s when it’s time to sell. By the time recovery is obvious, the price gains are long gone. Re-gardless of the court decision, AA’s pricing power is nil and its returns on capital are pitiful. In a final blow, Fitch cut their rating to junk. Being an aluminum producer is a tough business and AA is the dominant company. But little good can come of holding at these prices. I wish them luck and I recommend you sell, subject to tax consequences.

Trefis Key Drivers:

Alcoa reported a first quarter revenue decline of about 5% year-over-year due to aluminum prices that were 8% lower than in the prior year period, in addition to smelting capacity reductions. Aluminum prices did surge in early April due to the aforementioned favorable court ruling; however, Trefis does not expect further near-term upswings as structural factors remain largely unchanged. Aluminum prices have been adversely affected by factors such as slowing Chinese growth and uncertainty in the Eurozone in recent quarters. Given that many of the issues have yet to be resolved, it seems unlikely that there will be a sustained, significant rally in the near future.

The Berman Value Folio A Trefis Interactive Portfolio Report

Market Capitalization

Annual Revenues Dividend/Yield 52 Week Range

$15.8 B $22.7 B $0.12 / 0.9% $7.63—13.70

5

COMPANY HIGHLIGHTS

United Technologies

United Technologies (UTX) reported $14.75 billion in first quarter revenue 2% higher than a year ago. Net income was 5% lower at $1.2 billion. UTX is a great company. Its focuses on three primary areas: aerospace, HVAC systems and elevators—and dominates in all. Returns on invest-ed capital has averaged 12.38% over the past decade while earnings per share have grown at 10% annually, including during the great recession. A 1.89% dividend yield is icing on the cake. UTX is not as cheap as it was—on the heels of a 41% return in 2013. But I believe UTX is the type of company, unlike Alcoa, that you can own for a long time. UTX’s dominance keeps competitors at bay. As I’ve written in the past, UTX is leveraged to the future “verticalization” of urban areas: if you build a tall building, there’s a good chance it will have Otis elevators and UTC climate con-trol. Owning a piece of those franchises is likely to be very profitable for some time to come.

Trefis Key Drivers:

United Technologies’ first quarter sales growth was driven largely by the global commercial aviation sector and the U.S. housing market, partially offset by weak U.S. military sales. As airplane manufacturers raised production rates in response to soaring orders, UTC saw an increase in its commercial engine and airplane component shipments. Meanwhile, results at the construction and housing market-related segments - Climate, Controls & Security (CCS) and Otis - also posted healthy growth on higher demand from the U.S. housing market and recovering construction spending from Europe. Demand from the U.S. housing market led to a 21% increase in HVAC sales, and management expects that momentum to continue going forward.

The Berman Value Folio A Trefis Interactive Portfolio Report

Market Capitalization

Annual Revenues Dividend/Yield 52 Week Range

$108 B $62.6 B $2.36 / 2.0% $90.30—120.66

6

COMPANY HIGHLIGHTS

I’m downgrading Apple (AAPL) to a hold on valuation. The recent news of increased buybacks (from $60 billion to $90 billion), a 7-for-1 stock split and better than expected sales have con-verged to send AAPL up to nearly $570, a price level it has not seen since 2012. As I’ve written in the past, AAPL is worth up to $600 per share even without new innovation. Beyond that price, AAPL must actually create to justify. I don’t have any faith in my ability to predict whether AAPL (or any tech company) can reinvent itself and its products. I file that in the “too hard” folder. I continue to feel any decision around AAPL has to assume the worst case scenario: that its days of world-changing dominance are behind it. This could go into the sell column soon, but I hesitate to pull the trigger under $600. I’ll keep you posted in future issues.

Trefis Key Drivers:

Apple reported strong fiscal Q2 (ending March 29) earnings , beating guidance on both revenues

and gross margins, driven by strong iPhone sales. Each of the iPhones in the market sold better

than their predecessors in their respective price ranges, and the new carrier signings in NTT

Docomo and China Mobile provided Apple with a strong boost in Japan and China. This more

than offset disappointing iPad sales, which declined by 17% year-over-year, and the company

posted its best non-holiday quarter ever. Trefis expects the company to maintain its strong

performance in the near term, even without accounting for any potential new products.

The Berman Value Folio A Trefis Interactive Portfolio Report

Apple

Market Capitalization

Annual Revenues Dividend/Yield 52 Week Range

$508 B $176 B $13.16 / 2.3% $389—596

7

COMPANY HIGHLIGHTS

Pfizer

Pfizer (PFE) appears to be rushing headlong into that dark jungle called an overpriced acqui-sition. I wrote about PFE last month saying I thought patience was still justified with this bruised and humbled drugmaker. After many years (and much suffering in relative silence), that patience has finally expired. PFE announced the desire to acquire Aztra-Zeneca (AZN) and to chase the bashful AZN with ever increasing, desperate bids—the most current of which tops $100 billion. With an $87 billion market cap that already looks overvalued, AZN is a poor bargain. I can’t deduce an intrinsic value on AZN over $75 billion, but maybe I just don’t see the vaunted “synergies” that will supposedly materialize under this deal. I won’t wait around to find out. PFE is up on the announcement, so the market likes the news. I have no problem betting the market is wrong and accepting its generous offer. I’m selling PFE.

Trefis Key Drivers:

Pfizer’s research and development (R&D) expenses have been declining in recent years, as the company seeks to optimize its expenses and divert resources to key growth areas such as oncology. R&D expenses declined by over 10% year-over-year in both 2012 and 2013, and the company has estimated that they will be about flat in 2014, indicating management’s commitment to capping these costs. The company is reorganizing its business into two “innovative” segments and one “value” segment, which should lead to better focus and more efficient resource allocation going forward.

The Berman Value Folio A Trefis Interactive Portfolio Report

Market Capitalization

Annual Revenues Dividend/Yield 52 Week Range

$200 B $51.6 B $1.04 / 3.4% $27.12—32.96

8

Total return is calculated since inception date of 12/21/2011 and includes reinvested dividends. When a stock is bought in the portfolio, it is added on an equal cash-weighted basis at the time of purchase.

THE BERMAN VALUE FOLIO As of May 1, 2014

The Berman Value Folio A Trefis Interactive Portfolio Report

Ticker Name

Buy Hold Sell Purchase Date Purchase Price

Market Price

Total Return Since Purchase Date

Trefis Estimate

Basic Materials

AA Alcoa Sell 12/21/2011 $8.87 $13.47 56.4% $9.24

MT

Arcelor-Mittal Buy 9/21/2012 $16.06 $16.24 3.6% $16.03

RIO

Rio Tinto Buy 1/31/2014 $53.15 $54.29 4.1% $54.92

Consumer

PG Procter & Gamble Buy 12/21/2011 $65.84 $82.55 34.4% $70.29

Energy

BP BP Hold 12/21/2011 $41.33 $50.62 34.3% $48.41

Financial Services

BK BNY Mellon Buy 12/21/2011 $19.43 $33.87 82.5% $35.01

C Citigroup Hold 12/21/2011 $25.74 $47.91 86.6% $53.13

JPM JP Morgan Buy 12/21/2011 $32.12 $55.94 86.3% $62.07

Pharmaceuticals

PFE Pfizer Sell 01/21/2012 $21.90 $31.28 54.2% $33.56

Tech, Media, Telecom

ADP ADP Hold 12/21/2011 $53.21 $77.96 56.3% $72.84

AAPL Apple Hold 2/21/2013 $444.99 $590.09 35.9% $638

CHL China Mobile New Buy 4/30/2014 $47.40 $47.40 — 53.27

EBAY eBay Hold 12/21/2011 $30.18 $51.83 71.7% $59.70

IBM IBM Buy 2/28/2014 $185.17 $196.23 6.5% $227

PAYX Paychex Hold 12/21/2011 $29.14 $41.81 56.1% $35.22

Industrials & Transportation

CSX CSX Buy 12/21/2011 $20.80 $28.22 42.3% $26.02

UPS UPS Buy 12/21/2011 $72.40 $98.43 44.9% $102

UTX UTX Buy 04/21/2012 $80.40 $118.33 53.1% $121

Total 74.6%

PORTFOLIO CHANGES

I’m buying China Mobile (CHL) on its juicy free cash

flow yield (p. 4). I’m selling Alcoa (AA) on valuation

and pricing power (p. 5) and selling Pfizer (PFE) on

a bad deal in the making (p. 8).

Disclaimer

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The Berman Value Folio A Trefis Interactive Portfolio Report