Reading Berkshire Letter Leads to Bullish Outlook

Introduction

In order to guide my investing for clients to better futures, I am a student of markets and people. As with a number of others I spent Saturday morning reading Warren Buffett’s thirty page shareholder letter, edited as usual by Carol Loomis. Unlike others I was not disappointed with the letter for I did not expect a discussion of potential successors to the young Charlie Munger (92) or Warren (85) himself. Further I felt that this was not the likely forum for a discussion of current underperformance. As usual, I found the letter to be rich in investment lessons. A full academic year devoted to the study of Berkshire Hathaway would be better spent than on many graduate investment courses and at least one of the three Chartered Financial Analyst (CFA) exams.

Four Berkshire Lessons

The first lesson requires one to examine and think about the very first page of the letter. The first page shows the year by year performance of the company’s book value, market value of the shares, and the performance of the S&P 500 with dividends included; a remarkable fifty year record. For reasons to be discussed a little later I ignored the book value column and focused on the market value changes and the S&P 500. A quick tabulation will show that there were eleven down years and nine when the gains were less than the market. Thus for some 40% of the time there were annual disappointments, but remember over this period in aggregate the gain was 1,598,284% or 20.8% per annum. Two critical observations of the math: first, if one of the world’s best long-term investors can deliver some disappointment 40% of the time, we should not hold ourselves or our investment managers to a higher standard. The second observation: in a secular expansion enough of the time the upside is bigger than the downside. This is similar to one of the lessons from betting at the race track which is that if you are careful with your money you can walk away most days cashing only one of three bets.

The fund analyst in me suggests that a stock-only index is inappropriate. Berkshire has always carried a great amount of fixed income in its portfolio. To some degree this is offset by the large float from unpaid future claims that leverages the company’s own equity. I would prefer the comparison to be made to the Lipper Balanced Fund Index which we use as a benchmark for our mixed asset accounts.

Book Value is not a Good Measure

Warren Buffett attacks the use of book value, even though he displays it. He quite rightly points out that the accountants only allow write downs to historical costs, not any write ups. I agree and carry these concerns further to the calculation of tangible capital per share which is used widely in bank presentations. The difference between the two Goodwill numbers is deducted from book value to derive tangible capital. Because Berkshire, is in its own words, a “heavily asset sensitive” company, some may view the company as largely a financial that will benefit from rising interest rates thus a focus on tangible capital could be useful. (As both a buyer and seller of intellectual property companies, I question the mathematical expression of Goodwill, not its long-term utility.) In the early days when Berkshire Hathaway was essentially a public investment holding company, book value or what we call in the fund business net asset value was useful, but not recently as the company is growing its operating asset base.

Conversion of Investment Assets to Operating Assets

For some time and increasing recently, Berkshire is using its investment analysis skills to recognize external companies or parts of companies that could be more attractive than portfolio holdings. The report mentions two that will become significant operating earnings producers next year. Precision Castparts Corp. (PCC) which was originally a relative small investment holding which led to a complete purchase. Duracell was owned by Procter & Gamble and was acquired in a stock swap transaction which was similar to one Berkshire conducted earlier when its shares of the old Washington Post, now known as Graham Holdings, were exchanged for Graham's television stations and other operations.

The key lesson here is that when Berkshire can find attractive operating assets at reasonable prices, it would rather own them than publicly traded stocks. In effect Berkshire is buying private equity. Apparently it can do this well. I am concerned that far too many institutions are being sold units in private equity funds. I suspect that private equity funds with their need to put their raised capital to work before they raise their next fund will overpay for private companies and reduce somewhat the opportunities to buy good private companies at a reasonable price. For some private owner/operators, Berkshire presently can be more attractive owners than the more transient private equity funds.

Bullish on Investing

Because of expected productivity growth partially due to technology, and a global secular growth of more people entering the markets for goods and services, over time the economies will grow. One of Berkshire Hathaway's investments is in Goldman Sachs which we also own. Almost one quarter of Goldman’s work force is in its technology division with 80% involved with programming. Clearly much of what they are working on is to comply with control and compliance needs, however I suspect that they are using these talents to find new, improved ways to make money. (JP Morgan Chase has similar efforts on a bigger canvas.)

Other Inputs

At JP Morgan Chase’s Investor Day, CEO Jamie Dimon, stated that within twenty years China is likely to be the home of over 35% of the world’s billion dollar companies. Others have noted that Beijing has more dollar billionaires than New York.  

In January, which was a brutal investment month, according to the ICI domestic equity funds had net redemptions of ‑$15.6 billion, but there were two groups of funds that had positive sales; World Equity Funds + $10.4 billion and Municipal Bond funds +$ 4.3 billion. Not everyone is retreating.

Bottom Line

While it is popular to believe that interest rates will remain depressed for longer and therefore investors should be reducing their risks, I am taking the opposite view. The absence of bulls makes me bullish, in part because if I am wrong, there is little risk. The reasons that Warren Buffett and Jamie Dimon are buying are not the same as mine, however in the long run I believe we are doing the responsible thing.

Question of the Week: When was the last time you bought some equities?

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Avoid Incomplete Data + Overconfidence

Introduction

Far too many investment mistakes can be blamed on incomplete data and overconfidence. In the real as distinct from the theoretical or academic world it is difficult to avoid these traps that have hurt us from time to time. The best that we can do is to be aware of the traps and to avoid putting too much confidence as to “what we know.”

Focusing on the Wrong Measurement Gaps

Perhaps Larry Summers was reading my blog post when we I was questioning the validity and perhaps the utility of building government and financial policies on Gross Domestic Product. My concern is that there is little or any attempt to include unreported income within GDP. The former President of Harvard, Secretary of Treasury, and frequent pundit stated that he wished to abolish large denomination currency bills, for instance the $ 100 dollar bill and similar sized notes in other currencies. His view is that these pieces of paper are mainly used by those involved within the higher echelons of the underworld. At least with that projection I believe he is largely accurate. But he is missing a far more important set of facts published by his own organization. The Harvard Kennedy School found that the US Tax Gap on unreported income was 14.5% of reported tax liabilities in 2006. Other countries have different degrees of shortfalls: UK 6.4%, South Africa 23%, Bangladesh 36%, Thailand 53% and Pakistan 70%. On a global basis someone at the UN felt that the global tax gap was $2.1 trillion.

As far as I know, no one has taken these tax gaps and other less than complete estimates to adjust various GDP figures. Any student of high end purchases should question the sources of the money spent and saved. I have felt that observing the inhabitants of leading countries might be a more valid factor than what one could derive from government statistics. Since ancient times as soon as many people became wealthy in their own eyes and after fulfilling the needs for conspicuous consumption they found acceptable ways to both invest and to hide some of their wealth. They have been doing this long before there were paper currencies. Abolish paper and there will be substitutes, physical and perhaps electronic.

My real concern is that the growing size of the hordes of large currency is probably the best clue as to the size and growth of unreported income. One expert believes that some small businesses and trades people could approximate 50% of their activities as transacting below the tax radar. As a student of both history and human behavior I do not expect radical changes in behavior. What I am concerned about is almost every top/down pontification by political and financial pundits starts with a verdantly express view as to what GDP will do in the immediate future, and therefore various proposed actions are appropriate. Yet the statistical base of their argument is inaccurate and possibly seriously flawed.

Thus until governments around the world massively increase the money they spend on gathering and analyzing their data, Professor Summers please do not now take away an important source of the growth of real world wealth just yet.

Overconfidence

Just as I believe that high confidence in GDP and many other government statistics is unwise, our uncritical confidence in future actions should be avoided. This is very tough to do. In our very busy lives we do not have time to cognate about future implications of present or past actions. One of the characteristics of the human race is the ability to convince others. Those that are better at this than others are our marketers. They often start with given themes for their targets to choose. The salespeople have learned to keep their pitches compact, or in their language “Keep It Simple, Stupid” or the KISS principle. That doesn’t always work out well. As a professional investor or perhaps a surviving professional skeptic, I need to always guard against the exhilaration of an enthusiastic pitch.

Washington’s Mistakes

We can always learn from properly portrayed history. Saturday night my wife Ruth and I attended the birthday celebration for General George Washington at his Mount Vernon home as we try to do each year. Saturday night’s principal speaker was Nathaniel Philbrick, who talked about his forthcoming book Valiant Ambition, on the implications of the interactions between General Washington and Major General Benedict Arnold, an eventual traitor to America who could have caused the US to be militarily defeated. The interesting part of the discussion was the author’s contention of Washington’s ability to learn from his many mistakes. He changed his strategy from one of highly confident and occasionally well-executed battles in my home state of New Jersey and less successful battles elsewhere, to an eventually successful war of attrition that was increasingly unpopular in England.

Our Own Historical Experiences

I am always trying to learn. As a long-term investor with a fiduciary responsibility I need to be on guard as to the power of our own historical experiences. We should look well beyond our own experience to those of others in different times and places. At some point in the past, based on their experience, too many home buyers, underwriters, and mortgage owners thought that house prices would only periodically stay flat or rise, never decline. (I have not read the book or seen the film “The Big Short, which I am told is excellent. I have been reluctant to see it for it does not place the original cause for the collapse at the feet of the US Congress.) Obviously, with 20/20 hindsight it is clear all the way along the chain there was overconfidence. Part of the KISS principle in selling this paper was the growing population and their supposed growing wealth. Often one heard “Demographics is Destiny.”

Some of the same argument has been put forth for investing in Emerging and Frontier markets particularly in securities of consumer discretionary companies. In many cases these pitches drove the valuations for these securities way above those of somewhat similar companies in the developed world before they recently corrected. This is not to say that they may now be more realistically priced. (Some of these stocks are found in some of the mutual funds that we own for clients and ourselves.) The vastly reduced level of confidence and increased level of investment research improves the long-term odds for those that are patient.

At the moment I am wondering whether there is a nexus of incomplete data and recently-experienced overconfidence. There is a well documented rush to own passive index funds either through mutual funds or through companion Exchange Traded Funds (ETFs). For those who own these securities there is a high level of confidence that history will repeat itself and these vehicles will perform relatively well. The incomplete data part of the picture deals with off board trades, the aggregate size of the intraday trading long and short, the financial condition of the market makers and authorized participants that can create and contract the size of an ETF. Further correlations within markets are widening with very few large cap stocks rising and pushing major indices higher whereas the majority of stocks within the S&P 500 declined in 2015. Other signs of changing demand include an increase in the level of the VIX. Further, over the last sixteen years bonds out- performed stocks, while some believe that for the next sixteen years stocks are expected to outperform bonds.

Change in the structures of demand for securities is likely to cause a change in the structure of the market that was not anticipated.

Question for the week if not the year: What changes in the structure of the market are you prepared for?

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Four Investment Traps to be Avoided1. Asset Allocation 2. GDP & Unemployment Statistics 3. Co-Investor Risks 4. Statistical Record vs. People

Introduction

In an imperfect world I am always studying to see what I can learn that will help my clients to make smarter decisions. As an analyst I have never been satisfied with any given number as a complete summation of past or present events. In this search I often question the perceived accepted knowledge. Often I find the summary is either incomplete or wrong in the terms of usefulness for future decision making. This blog post deals with some of the generally accepted views.

Asset Allocation

As we all are very much aware, investment performance has left a lot to be desired recently. In preparation for an upcoming client discussion I was considering some managers of funds that put a great deal of faith in allocating portions of their portfolios to different asset classes- equity, fixed income and cash and whether their decisions led to better investment results. One of the fortunate elements of my investment practice is that I have easy access to my old firm’s data. Lipper, Inc., a ThomsonReuters company has produced a computer service known as Lipper for Investment Management. With some help, I asked to see the investment performance of Multi-asset mutual funds for the one year period ending January 31^st, 2016. I compared the results with the proportion of each portfolio in the three main asset classes. The universe contained 433 funds. Some of these funds were the old Balanced fund type, some were Target Date Funds either with fixed or managed allocations; others were flexible funds that regularly used the three asset classes. Further I focused on the top quintile in each sort of performance and asset classes. Thus to be in the top quintile a fund had to be in a select group of 86 funds. Over this particular period the universe on average produced a small single digit loss. The single best fund was up + 3.14%.

One would have thought that the funds that had the highest portion of their portfolios in cash would have done the best in view of the general market decline. Only 21 out of 86 of these funds were in the top performance quintile. Only 32 funds with the largest commitment to fixed income also were in the top performance quintile and finally 55 of the equity funds were in the group that showed the best results.

My working conclusion, assuming that this specific one year time period is representative of some future periods, is that while asset allocation can help performance it is less important than selection of individual securities. In the case of Lipper Advisory, as a manager of portfolios invested in funds, the individual selection of funds can be more important than sole reliance on asset allocation. (As this is a somewhat contentious opinion, I look forward to hearing from our subscribers with their views.)

GDP & Unemployment Statistics

Market pundits as well as politicians spout GDP and unemployment numbers as if they are accurate and meaningful. To me they are not to be used for decisions but as indicators as to what other people think who don’t spend time with people in the marketplaces of commerce and finance. It is these people as decision makers of both small things as well as large that affect the real world. That is why markets often move differently than the perceived numbers. While not as bad as the Argentine inflation numbers, which the new government is addressing so all can understand what is really happening; the US statistical budget has been starved for more than twenty years on an inflation-adjusted basis. Part of the problem with most countries’ GDP data is the failure to recognize the unreported numbers. One clue in the US and the Eurozone is that the fastest growing portion of both currencies is in large denomination bills, 100s and 1000s. You can guess who needs these and what they do with them. Further in the US there are at least six different measures of unemployment. If one takes the most severe and subtracts that from those employed the proportion of the population is indeed still large. Some might even suggest that these two factors (the under-reporting of GDP and the most severe unemployment) could be connected.

From my standpoint I do not put much reliance on the government produced numbers. I find it interesting that when the Presidents of the local Federal Reserve Banks get together they are questioned as to what have they learned from their interfaces with their local communities. Investors and portfolio managers do the same thing. Thus, my suggestion is to follow the markets for the best near-term feel as to direction.

Co-Investor Risk

Too many investors, including professional investors, focus on the risks of the issuer of the securities they own or are considering. To me there is almost always a bigger set of risks. The risk of my co-venturers in the security is the bigger risk. If enough of them want out immediately before I want to exit the security, their selling can damage my terminal price.  The current prices of financial securities are a good example. The MSCI Europe Financials index through February 11^th is down ‑32%, the KBW Bank Index is also down ‑19% (26% since July) with the S&P 500 only down ‑8.8%. While there are some more non-performing loans in Europe, particularly in Italy, most Bank analysts believe the majority of banks are in better shape than when the last crisis hit. I believe the reason for the materially larger decline in bank securities is the fact that 45.9% of the oil-related Sovereign Wealth Funds were invested in financials. By the way, perhaps I am the only one that got nervous when we were told that Jamie Dimon bought 500,000 shares of JP Morgan Chase^* stock on Thursday. This action reminded me of the quote from Mr. JP Morgan in 1929 that he and his son were buying. In the earlier case it worked for awhile but had no lasting stock price benefit. We will see what is the impact of Jamie’s purchase.

*Held in a personal account.

Statistical Records vs. People

There were lots of lessons from last weekend’s Super Bowl. There was no doubt that on the surface the Carolina team not only had a better record as well as a younger more athletic star quarterback, but they lost in a not too close game to the Denver team driven by a few very aggressive defenders who forced the supposedly better team to make mistakes. This reminds me that at times and under appropriate circumstances we select to invest with managers who we think are good and determined over those that have better records. Sometimes statistics can lead to the wrong decisions. Currently in the stock tables General Motors’ price/earnings ratio is listed at 5.5 times. This is historically cheap and therefore to some, attractive. We don’t follow the stock, but I wonder whether looking forward, the market is saying that the stock is selling more like 15 times or similar to the overall market or perhaps higher because the long-term outlook is for materially lower than recently reported earnings.

PS:

I am writing this blog post on Sunday evening, watching Bloomberg Television over my shoulder and seeing the Chinese-related markets are opening down even though their currencies strengthened during the Lunar New Year holiday.

I will be in my office on Monday.    

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Comment or email me a question at: mikelipper@gmail.com.

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Copyright © 2008 - 2016

A. Michael Lipper, CFA,
All Rights Reserved.
Contact author for limited redistribution permission.