Sunday, February 26, 2017

Critical Lessons from Two of the Smartest Investors


Trying to escape reliance solely on experience, I rely on my student skills for this post. I have indicated numerous times that the Neuro-economics professors/scientists at Caltech have shown most people use their cumulative experience as the main or sole basis for making judgments. I try to study current and past history as an important source of additional experiences.

This week I have turned to two of what many have called in their time the smartest men around, Sir Isaac Newton and Warren Buffett. The latter's annual letter came out Saturday morning and I read it before we drove to Mount Vernon to celebrate General George Washington's 285th birthday. While the letter was signed by Warren, it clearly contained some of Charlie Munger's insightful views and was probably edited by the incomparable Carol Loomis.

Sir Isaac Newton

Sir Isaac is acclaimed as  the identifier of the laws of gravity. For many of us market followers this is often translated to what goes up, comes down. We always hope that our particular investment will either continuously rise or we get off the back of the market tiger successfully before he runs in the other direction.

At this particular point I have been focusing on Sir Isaac's investment activities to guide my clients' and family's investment accounts. For almost any gathering of people who are involved with the market the question comes up, “Should we sell after this remarkable rise we have had in many stock markets around the world?” I should not claim forecasting skills, but I can serve up lessons from history.

The South Sea Company was what we would call today an unusually clever public-private partnership that was founded in 1711. The company was awarded a commercial trading monopoly with the lands in the South Seas (South America) and for this the company would assume the war debt coming out of the War of Spanish Succession which ended with the Peace Treaty of Utrecht in 1713. Originally the promise of the company was a 6% yield, but as the government offloaded more of its debt on the company, the promised yield was dropped first to 5% and then 4%. In the Peace Treaty the monopoly was translated to mean one ship a year and there were some restrictions as to the commodities to be traded, but with the fabled gold and silver production in South America the ownership of this team of wealth was deemed to be very valuable. In January of 1720, not quite 400 years ago, the stock was trading at £128, in February £175, March £330 and £550 in May. Somewhere in this parabolic price rise, Sir Isaac (being well trained in mathematics) sold out. Well and good for our hero.

The only problem was that on the way to its ultimate peak of 1000, Sir Isaac got sucked back in, and when it collapsed to 100, he had lost £20,000. According to one account that the loss would be worth £268 million today.

(For those who are interested I would be happy to discuss this bit of history and the roles of the government, the main bank, and other bubbles.)

One of the risks of using the past as a measuring device is that occasionally one can be premature and in some cases quite premature. It is not too bad missing the last opportunity at or near the top. The real penalty is borne by those who get sacked back in by envy and the belief that they can identify the top and go back in and stay in during an unconscionable decline.  I guess the best defense system is the willingness to accept both the loss of presumably large opportunity and actual realized losses during one's hasty parachute exits. 

With the lesson from Sir Isaac Newton's experience in my mind I am paying increasing attention  to expressed sentiments triggering actions. For example, according to one report, Renminbi transactions accounted for over 95% of total Bitcoin exchanges. I am seeing what I believe to be similar activities in some commodities as many Chinese are desperate to get some of their wealth out of their own currency. Further, I see some signs of potential large disruptions in  currencies and treasuries. My concerns are based on the fact that these markets are bigger than the stock markets and through margin and derivatives  heavily committed traders could quickly come into insolvency. This would be too bad for them and their investors. However, it could be very unfortunate to their counter-parties. Often these very same organizations supply credit and facilities to other market participants which could cause a disruption in the stock markets no matter what their level, but particularly if stock prices reflect an increase in speculation.

The Buffett Letter

I suspect that the lead item in Monday's financial press will be about his shareholder's letter released early Saturday morning.  Most of the focus will be about  the value of Berkshire Hathaway shares. As usual I will not compete, but focus as to broader implications on the report as if both Warren and I were back at Columbia.

The 52 year record of performance of Berkshire-Hathaway is truly remarkable. What struck me was over this period there were eleven years when the market value of Berkshire's shares went down and eleven years when the S&P 500 went down. What was interesting is that in eight out of eleven they were different years. This suggests to me while both time series produced good results (20.8% for Berkshire and 9.7% for the S&P 500), they are not good tracking devices for each other. Thus they are not well correlated to each other. One of the reasons I suspect that many accounts that are broad market index centered will be underperforming is that the correlations in today's market is widening. This theme was repeated in a couple of examples from the letter.

Every year since 2002 the operating income, including interest and dividends has produced more for the shareholders than capital gains. These results are the product of a relatively low turnover of its securities investments and the increasing shift to buying companies rather than securities.

The preference of Buffett and Munger to buy whole companies is producing better long-term results than buying publicly traded securities.  This is due to trading, when appropriate, the absence of dividend requirement and the ability to leverage. Other corporate investors have seen this as well which in turn has led to an absolute shrinkage in the number of US publicly traded companies. Further, there are fewer mega cap companies that can profitably use the ministrations applied by Berkshire and ValueAct.  Thus, I suspect that there will be more acquisitions made and there will be some medium cap deals that show larger potentials will be acquired. 

Berkshire reports the earnings of Clayton Homes under Financial and Financial Products rather in their manufacturing complex. While the bulk of the revenues for Clayton comes from manufacturing homes the bulk of the earnings comes from its mortgage operations. There are many public companies and their subsidiaries are similarly misclassified  compared to the better security analysis exercised by Berkshire. In a similar vein, many sector and industry index funds  have  been characterized improperly. Again this may come back to haunt certain sector and industry index ETFs.

All investors and their managers should be indebted to Warren Buffett's page 22 where he shows the almost ten year record of Protege Partners choice of five fund of funds,  which include some 100 individual hedge funds' annual performance from 2008 compared with an S&P 500 index fund. For the nine completed years, the S&P fund was the best in five years. The best of the fund of funds beat the Index fund four times and the others one to two times. What I take out of this are the following:

1.  It is difficult to the beat the market .
2.  The market indicator does not win in each year.
3.  In its best year the index was up +32.3% and worst was off -37.0%, both of more are reasonable expectations for some future years.
4.  It is quite possible that the funds suffered from over-diversification and this is true particularly true versus Berkshire itself.        

In Conclusion

One wag has suggested that the only thing the markets are guaranteed to create is humility. Thus, as a never-too-old student I hope to learn from others, so I make fewer investment mistakes and hope you do as well.
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