Sunday, August 16, 2015

Money Management Lessons


Successful money managers do much more than select winning stocks. They use weighting of their selections, timing of their transactions, partial trading actions and timely admitting of mistakes.

Lessons from Berkshire Hathaway

On Friday the investment press was full of stories from the latest release of Berkshire Hathaway’s transactions for the quarter. All of these reports focused exclusively on the names of the stocks that were bought and sold and none on the structure of the overall equity portfolio. Thus, their readers missed the opportunity to learn how the portfolio is managed.

The company has at least eleven equity reporting elements excluding the investments in their retirement accounts. Many equate the company to an open end mutual fund, which is a mistake for in all of my work on US and foreign registered funds I have never seen a portfolio that truly operates on the same basis.

First, Berkshire’s equity portfolio is part of a complex series of holding companies which include fixed income securities, liabilities, and substantial float of “temporary” money that can be invested. Second, with rare exception there is no pressure to liquidate assets to meet immediate redemption orders. Third, one of the great assets the company has is its brand. In times of financial distress on the part of others, the company can demand very high returns for the use of its money to prop up the market value of large, high quality companies which may be viewed as in distress. Fourth, the company can be extremely patient and at the same time make very rapid decisions without the need for committee or board actions. (These are some of the reasons that I am happy to be a long-term shareholder for a fund I manage and personal accounts.) In my mind these attributes are worth a premium over book value or if it were a fund, net asset value.

Regular readers of these posts have learned that I count the lessons that I learned at the race track as important guides to my professional investment practice. Let me define a winning day at the track, which is an enjoyable day in a pleasant surrounding and walking away from the track with more money than I had before I got to the track. As Yogi Berra is reported to have said, “You can see a lot by observing.” I have seen numerous “horse players” that have cashed winning tickets, but at the end of the day they are not qualified for my definition of having a winning day because they go home poorer. Their mistake was not in failing to pick winners, but in handling their money poorly. Often they made too many bets, spent too much in meals and other entertainment, increased the size of their bets to obtain break even and accepting of low odds by backing favorites.

In general Warren Buffett, Charlie Munger, and their two investment managers are guilty of these mistakes in managing the Berkshire stock portfolios. As of June 30, 2015 the reported total of the stock portfolio was $ 107.2 Billion. Only four stocks represent 62.38% of the total, and another eleven stocks represent 27.01%. This last group of eleven individual holdings were each 1-5% of the portfolio. There was another 11.61% spread through 31 names. While for some purposes I like concentrated mutual fund portfolios, I can find very few that would be this concentrated and they would have redemption problems where Berkshire does not.

In looking at their recent trading history one sees that many of the positions are traded somewhat actively; enlarging and contracting the size of the position and often changing the tax cost basis of the holding. These are done for investment purposes not to accommodate flows which is often the case with funds. While Berkshire is a prodigious net cash generator, I do not expect that there will be a large flow into the current equity portfolios as the latest 100% acquisition absorbs a good bit of the company’s preferred cash cushion or strategic reserve which can be deployed within 24 hours on a potentially highly profitable rescue mission. Perhaps most importantly, after due consideration, Berkshire will liquidate a holding at a considerable loss and admit that they did faulty analysis rather than blame external events.

If I were to recommend a Berkshire-type strategy for a managed account today, it would have a sufficient opportunity reserve to be able to take advantage of rapidly attractive situations when others are fearful. Further, I would use investment judgment in weighting my portfolio, something my older brother has been saying for some time. I would be selective in my diversification by only one or a few stocks in a sector, typically the best of breed. I might have some very small explorative positions with a sense of how long I would be willing to hold them. Most importantly I would try to be disciplined to admit analytical mistakes and discard losers regardless of costs.

Another valuable lesson from the Racetrack

On Friday there was a long and glowing obituary for John Nerud who died at 102 after saddling over 1,000 winners as a trainer or farm manager. He was the best and worked for a great and generous owner. The lesson is that one can get the horse wonderfully prepared to win the Kentucky Derby, employ one of the best jockeys and give him good instructions. In this case when Willie Shoemaker was leading with Gallant Man, the jockey mistook the finish line and stood up briefly in his stirrups and let another horse win the Derby. A few weeks later Gallant Man won the much more significant Belmont Stakes proving that he was best three year old in the country. The lesson is that bad things unexpectedly happen and we should not expect perfection in our choices, even when they are eventually proven to be correct.

Another Numbers Lesson

Many value managers make their case on the basis that their holdings are selling at low multiplies of stated book value.  While I am a believer in buying something at a discount from what a knowledgeable buyer would pay for the asset, I have little confidence in the book value calculation. Book value is derived from the balance sheet of the enterprise. These are largely based on historic costs on periodic impairment decisions by the company on the advice of their auditors. Rarely are assets written up, declines in market share are not recorded, contingent liabilities are not deducted, the value of expiring patents is not noted, etc. The auditors prepare balance sheets for creditors not equity owners. Too many investors equate book value with the total net asset value of funds. They understand that when they redeem their open end mutual funds they will be paid out on the basis of the current net asset value.

However, they fail to look at the way the market values net asset values of closed end funds. Open end and closed end funds use the same calculations and auditors. Because investors, through their brokerage firms, must find a ready buyer for their closed end sales, the market functions to bring buyer and seller together at an agreed price and time. Currently the discount on closed end funds to their net asset value is approximately 10%,  my friends at my old firm Lipper, Inc., tell me. Thus my starting point in looking at book value for companies before I reconstruct is to assume a 10% discount from stated value. After reconstruction of an updated appraisal of what a knowledgeable buyer would pay for the company my estimated book value is very likely to be higher or lower of stated book value. To me this is the proper approach for so-called value investors as distinct from “quants” who don’t see beyond the published financial statements.

Question of the week:
What circumstances would lead you to sell or to buy Berkshire Hathaway? 
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