Sunday, February 28, 2016

Reading Berkshire Letter Leads to Bullish Outlook


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.

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