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Subject:  GenRe and the S&P500 index Date:  12/21/1998  5:15 PM
Author:  TMFRalegh Number:  726 of 5674

Intrinsic value as Buffett or many good value-oriented people define it is "the net present value of all the cash that can be taken out of a business over its lifetime." And that's from here until the end of time. That's why Mr. Buffett uses "look-through" earnings in assessing the intrinsic value of Berkshire, in my opinion. The inclusion or dis-inclusion of Berkshire in the S&P 500 doesn't effect the vital moving parts in that definition. Therefore, it can't effect the company's intrinsic value. It can effect the market in the short-term. As Ben Graham said "In the short term, the market is a voting machine, in the long term, it's a weighing machine."

This is particularly pertinent to the situation with Berkshire's non-inclusion and GenRe's dis-inclusion in the S&P right now. In the short-term, it will effect the price, through perceptions and through the actual selling of GenRe by index funds and closet-indexers (the money managers that mirror big chunks of the index to keep up with the benchmark against which they're judged). But that is the voting machine at work, not the weighing machine. In the short term, the voting machine can be an 800 horsepower motor torquing the market price of a company. In the long term, the voting machine is a rubber band-driven toy car working against the Titanic boilers and engines of the drivers of intrinsic value. To distill that mixed metaphor, in the long term, the value of the company and the performance of the company will be driven by fundamental factors and not the workings of the S&P 500 index.

To illustrate, look at the performance of Cincinnati Financial before and after its inclusion in the S&P 500 index almost exactly one year ago. Their management has done one heck of a good job for their shareholders over the long haul, but since inclusion in the S&P 500, its share price performance has been negative. And that's during a year when the S&P 500 is up 20% through today. What's interesting to note is fact that the company's shares jumped $17 5/8 to $132 (pre-3-for-1 split prices) the day of the announcement of its inclusion in the S&P. But its performance since then (starting the measurement before the shares moved up on the S&P 500 news)* has been dictated by pricing and loss experience in the property & casualty industry. Its S&P 500 membership has been totally incidental to that and has not been able to save its share price from a deteriorating pricing environment, its own efforts to expand market share, or the market's perceptions on where the P&C industry is going in the foreseeable future, which you think best explains the company's share price performance over the last 12 months.

Inclusion in the S&P 500 will give a company a short-term boost, no doubt. After that, however, it's on its own in how the marketplace determines the price of the company and assesses its intrinsic value. Sure, the liquidity of the index can provide buying power for a company's stock when index inflows are huge, as they are now. But if index fund inflows drive up the price of a company past a price the market deems to be warranted, the non-index market players will react to that and sell into that buying. On the flipside, when the index tide goes out, the index funds will have to sell pro-rata shares of the companies in the indexes to meet their fund outflows. Theoretically, market players will step in and buy the stock if the index-driven selling takes the company below intrinsic value. But those are short-term factors. Over the long haul, that won't drive shareholder value. Those temporary moments of greed and fear will just provide opportunistic investors good buying points or, hopefully less often, selling points.

So, I just don't think being in the S&P 500 has anything to do with intrinsic value. It might help a company trade at its intrinsic value, but I'm doubtful about that. Tons of S&P 500 companies have traded under their intrinsic values for significant periods of time in the great performance of the index this century. McDonald's is a good example of that. About a year and a half ago, it traded near the value of its real estate without giving any effect to its restaurant and franchising operations and its brand equity. Berkshire has never been a member of the club and Mr. Buffett believes that its share price performance has tracked its increase in intrinsic value over the years. So I really think the value of the company is driven by fundamentals and that the S&P 500 membership is incidental. It's nice, but incidental.

*Its stock is down 11.5% (before dividends) from the price at which it was trading the day before news of its inclusion in the S&P 500. Its shares are down 27 1/2% from the price at which they closed on the day of the S&P 500 announcement.

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