Berkshire - Hathaway & Sequoia Fund: As Seen Through Alphabet, Amazon, and Apple

 Introduction

For the week that ended Friday one could focus on short-term price movements or long-term investment thinking. As my week evolved I did both, which produced positive, but disjointed conclusions.

Short-Term Price Actions

On Thursday prices fell supposedly in reaction to political events. As an analyst and portfolio manager trained in the school of contrarianism, I saw the reason for the decline differently. For some time I have been aware and have commented on the price gaps in the performance of the three main individual security price indices; Dow Jones Industrial Average, Standard & Poor's 500, and the NASDAQ composite. In each case the index had two days when  prices through the day were measurably higher than the high price achieved the day before. This price gap phenomenon rarely happens and most of the time a subsequent price action fills the gap before the market resumes its prior trend. In earlier blogs I had warned about this probability. Further, I quoted a knowledgeable market analyst who was expecting a 5% correction.

On Thursday the two price gaps in the two senior indices, DJIA and S&P 500 closed both gaps. By far the strongest index this year, the NASDAQ closed one. I would expect in the fullness of time the remaining price gap will be closed. Historically when the bulk of traders focus on the political issues of the day (in contrast to the financial inputs) their emotions are a bad guide to future investment price performance.

A less followed sign is the Confidence Index published by Barron's each week. The index focuses on the difference in yields between the highest corporate bonds and those of intermediate quality. In the week ending Friday, compared to the prior week, high quality bonds yielded 3.22%, down 17 basis points whereas the intermediate credits yielded 4.27%, down only 13 basis points. This suggests that in the week high quality bonds were considered better value than the higher yielding intermediates. Often this is considered a bearish sign for equities as bond buyers are opting for lower risk securities.

In assessing the value of these two observations it is important to understand that the judgments expressed are based on a feeling for the historical odds and not certainties. As noted in my earlier blog posts there are no pure laws of economics that guaranty the same level of certainty as found in physics. One should assign perhaps a 90% certainty to your favorite economic laws. Most so called "investment laws" would be considered successful if they were correct 70% of the time. Using a technique I learned at the racetrack, I multiply these ratios (0.9 x 0.7 = 0.63). This suggests to me that I would be happy if my analysis was correct 63% of the time. I can improve my dollar return by weighting some decisions compared to others.

General Sun Tzu

Other than the Bible no other text has been used more to teach the military than Sun Tzu's "The Art of War. Considering the importance that we are putting on the rapid progress of China it is very wise for us to remain conversant with China's greatest military scholar. Friday I was refreshed in my knowledge of the general's thoughts when good friends of mine who are life long investment experts on Asian investing gave me a book by Jessica Hagy, The Art of War Visualized: The Sun Tzu Classic in Charts and Graphs.

Since in many ways competitive investing follows the equivalent precepts as successful military warriors, I am going to apply the same principles to investing. There are five particular strategies that the General recommended.

1.  Victory can be achieved through measurement, estimation, calculation  and balancing chances. (In investing it is important to measure accurately what is there and even more important what is not there; e.g., BREXIT and the Republican swing, as well as incomplete financial statements.) These are some of the times when good estimates are critical which makes it essential to know how much reliance to place on calculations of the future. In discussing the short-term data above I showed one possible way to calculate different levels of uncertainties. All of these and other factors need to be weighed in conjunction to determine whether the odds of success are sufficiently high to undertake the risk to achieve victory.)

2.  Always be prepared to attack and always be prepared to defend. (Opportunities will always occur without warning.) A good investor must be able to quickly shift to an aggressive mode and just as quickly shift into defense. Most investors have too little in the way of reserves to dramatically "juice" returns, particularly if they are reluctant to sell or reduce less favorable positions in the new opportunity context. In terms of defense we all need to part with some of our least loved positions regardless of tax implications.

3.  There are dangers to be avoided: recklessness, cowardice, hasty temper, and rich appetites. (Many will find it difficult to react wisely to the opportunities due the dangers listed. As is often the case we can be our own worst enemy. The General called for sound discipline at all times.)

4.  Do not feel safe and be a good generalist full of caution.  (Quite possibly the biggest risk to our wealth is a feeling that we are safe. We are not on the outlook for possible problems, most of which won't materialize, but some or one can be like a hole below our boat's waterline. This can be caused by our bad navigation or an enemy torpedo, Perhaps at least mentally we should practice fire drills as well as abandon ship actions.

5.  An experienced General is never bewildered. Once some level of activity is commenced it is easier to accelerate or decelerate than to start to move from a standing stop. I am a believer, at times, of making partial commitments and at other times full actions. Often the key to an investment decision is not the action itself but how it positions a person or portfolio for subsequent steps.

How Sun Tzu Might Have Viewed the Actions of Berkshire Hathaway and Sequoia Fund Through Alphabet, Amazon and Apple

One is always at risk of misinterpreting or over simplifying by abbreviating some of  The General's thinking. For this exercise I am only going to focus on his first step to victory through calculation and his fourth, balancing chances. Almost all of the named securities (Alphabet, Amazon, and Apple) are owned by me or close relatives. However, the purpose of the ensuing observations are not meant to be taken as any form of recommendation. For those who are interested in converting the observations into actions, I will be happy to discuss my views tied to your specific needs, “off line.”

Berkshire and Sequoia share the same source of inspiration, Warren Buffett. Not surprising over the years they have owned some of the same stocks derived from their own work. The three highlighted stocks were recently discussed in investor meetings. The reason to focus on these three specific stocks is that it revealed their thinking.

Alphabet, the parent company of Google, was well known to both. Mr. Buffett’s view is one that was under its nose as it was extensively used by Berkshire’s subsidiary GEICO. It was just not in its universe, which is strange as GEICO is so advertising-centric (both they and I owned Interpublic one of the largest global advertising complexes recovering from very poor results). As it wasm't looking at Google, it was not in the calculation. This is similar to those who were following the polls prior to the BREXIT and Trump votes in analyzing data, perhaps the most important task is identifying what is not there.

To some degree Sequoia also had a calculation failure. Sequoia quickly grasped the advertising power that the Google search engine produced. However, it needed a "kicker" to be added to its calculation. The kicker was "AI" or artificial intelligence. Sequoia believes that Alphabet is "by far" the leader in AI, which it may be. My problem is that the current level of earnings from AI products or augmented services has not been revealed. In this particular case the lack of numbers on the AI effort was probably a factor in its balancing of chances.

Amazon is another example where the two intrinsic value investors disagreed. Because of Berkshire's operating experience it had some doubts that Jeff Bezos could succeed in the highly competitive distribution business. If he could succeed, it doubted that the same mentality that could build a highly successful distribution business could aptly handle the technologically challenging task of developing a commercial cloud business. I suggest that the financial analysts in Berkshire focused on the financials which showed robust revenue growth and marginal reported profits. Sequoia saw that the financial statement hid the internal process of taking substantial operating profits and reinvesting them into the cloud. Further, Sequoia probably saw that the keys to the success of Amazon's distribution business were based on highly automated warehouses and tightly controlled transportation. However, Sequoia like many of us, were captured by its collective experience. Bill Ruane the founder along with Rick Cunniff often focused on buying stocks "at the right price" and thus they did not buy as much as they should have as the price of Amazon went up.

Apple is another example where these two investment groups came to different conclusions based on their research methodologies. Sequoia in calling on Apple's management, could not get them to speculate what handset sales would be three years in the future, so they passed. Again the words of its founder were a hurdle. Bill said that they understood potato chips not computer chips. Berkshire only recently viewed Apple as a consumer not a technology company. They focused on both the "eco-system " that Apple was growing and the potential use of its technology and related skills in substantially new product categories not yet on the market. Interesting that both Berkshire and Sequoia want to invest in companies that have competitive advantages, which is often translated into unique products or services. Sequoia will sacrifice future growth for competitive advantage. Berkshire under Charlie Munger's prodding is more attracted to growth at a fair price. Apple effectively used the General's formula of balancing chances.

Bottom Line

As with all "school solutions" there is no guaranty of success. While the odds improve with a well thought out plan, nothing beats good execution. Thus, when we pick mutual fund and separate account managers we pay attention to both their investment philosophy and their history of good executions. More often than not good executions are the results of front line troops. That is the lesson that I learned as a US Marine Officer where it was my job to develop a plan of action and inform my senior non-commissioned officers of the plan and the logistics, communication, and heavy arms support, but let them carry out the mission as they saw how to do it. The same principle works at the racetrack. While I did not see the running of the Preakness the two horses that were leading coming into the homestretch had a good plan, but a third horse had a better execution and thus won the race.

As you can see I am always learning and hope to do so all of my intellectual life.

What are the sources of what you have been learning recently?

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Losses Lead to Profits, but Will the Fed Learn?

Losses are inevitable in all of life, including your investment portfolio. As a matter of fact, the only thing I promise to those whose portfolios I manage is that I will make mistakes for them, but hopefully they will be relatively small and quick, and that we learn from them.

There are four kinds of losses. The first is that the selection failed to deliver the expected result because the choice was fundamentally flawed. The second is a faulty understanding of how the particular investment actually works. The third is the right idea, but the wrong timing. The fourth and the most dangerous to the future of the people involved is not to learn from the losses. One of the few things I did not learn from my experiences in the US Marine Corps is my motto of “Blunder Forth,” but the key is to learn from past blunders and not to repeat them.

Diversification losses

Since few, if any of us know with certainty what either the markets or the economy are going to do, it is traditionally wise to hedge our bets. (This is why at the racetrack an occasional bet on second place or even third makes more sense than only betting to win, particularly in each race.) There are two active ways to hedge our bets. One is to sell something short. The second is to buy something which is likely to move in the opposite direction than the bulk of the portfolio is expected to go.

Many institutional and individual investors are hesitant to sell short because to be successful one needs to get one’s timing right. Too few have a good history of this skill. Many more investors look for contrary plays. Two of these are gold and TIPS (Treasury Inflation Protected Securities). The owners of these are betting that the current manipulation by the major central banks of the world will produce a decline in the value of major currencies or create a large bout of inflation. In the first half of 2013 neither of these calamities have occurred, therefore these bets are considered by many to be losers. In most institutionally managed portfolios the actual or paper gold (futures or gold mining shares), the gold holding is less than 10% and in many cases below 5%. The purpose of the holding is to act as a ‘canary in a mine’ to signal an abrupt change of conditions which has not yet happened. TIPS are typically held in a portfolio that also owns other bonds or bond funds. The combination of the bond holdings is meant to insure that when the bonds mature they will produce dollars that are equal in spending power to the level of the dollars invested initially. For most of this year TIPS have not been returning a real (inflation adjusted) return.

Are the investment in gold and TIPS losers? I would say no. Because of some investment in TIPS, a number of investors were able to have enough courage to own much larger investment positions that had a more positive outlook than if they had not owned TIPS.  I would go further by saying that a well-balanced portfolio could well be at its maximum risk of large losses when all of its investments are showing significantly positive results. It is unprepared for abrupt changes which have been known to happen.

However, there is a risk which overtook investors in 2007-2009. The risk is that the protective diversification schedule was trashed by the correlations (particularly on the downside) among supposedly uncorrelated assets. I am not at all suggesting that one should abandon diversification as a practice, but to be aware that there will be times that supposedly uncorrelated prices will move together and only a reasonable amount of cash or very short-term treasuries will supply some ballast to a rapidly sinking portfolio.

Will the Fed learn?

The two losing diversification investments mentioned above were meant to be good diversifiers against the actions of the US Federal Reserve Board (the Fed) and a number of other national Central Banks in attempting to stimulate their economies by depressing the natural risk-oriented interest rate levels. Perhaps it is coincidence, but this week I have become conscious of four separate but different comments that suggest that we are approaching a time when the structure of the Fed may be changing. In order of their first appearance to me the four are as follows:

1.   As mentioned in last week’s post I chaired a panel presentation on the impact of the media on the nature of “bubbles” with Bill Cohan and Jason Zweig at the Columbia Club in New York. As is often the case in these public sessions, the audience was less interested in history and more interested in what to do now. One of the speakers who is a good historian stated that the Fed is not very good about predictions. They have not done a good job of predicting the economy and worse, they have been poor on predicting what they would do in the future.

2.   A “Hindsight” column in the  New York Times, included an article by Roger Lowenstein entitled “The Fed Framers Would Be Shocked.” Roger is someone who has written widely on the economy and the market, he is the independent chair of the Sequoia Fund, a sound fund that comes out of the heritage of Warren Buffett’s original hedge fund. He focuses on the concerns of many involved with the passage of the act that created the Fed; that it would become too powerful and would drive the economy. The authorization of the second Bank of the United States was allowed to lapse because many feared control of our economic interests by a powerful unelected body which would likely to be heavily vested by the ‘money trust’ bankers. In some ways this was a replay of the battle between local control and national control, a battle that is still raging in education, medicine, and other arenas that people care about.

3.   The Bank for International Settlements (BIS) functions as the central bank for the world’s central banks. In a report released over the weekend, they urged the central banks to withdraw from the stimulus business. The BIS felt that the proper function of the central banks was inflation control not to provide growth impetus for their economies, which is a function of the governments and their fiscal policies. An interesting article was published Sunday by the Telegraph, entitled:
“BIS Fears Fresh Bank Crisis from Global Bond Spike.” 

4.   There is a bill in Congress which removes the double standard for the Fed by eliminating the responsibility to aid the growth in the economy other than by attempting to control inflation.

I found it interesting that all seem to be forgetting that the original purpose of the Fed was to substitute a public source of capital to troubled banks replacing JP Morgan’s policy of forced cooperation. (Morgan once locked the participants of a key meeting in his library to force agreement among the solvent banks to provide bailouts to the distressed banks.)

Quite possibly these and additional drumbeats may hasten changes in the proper use of the Fed. Others are learning from the recent past, it will be interesting to see whether the momentum for change will come from within the Fed or from external forces.

Conclusion

All of us, including the Fed can learn from our past losers or mistakes.

From what losers have you learned? Please share publicly or privately.       

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Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
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The Crowd Roared and Investors Cringed: Be Careful of Crowded Trades

Saturday night, my wife Ruth and I heard Mahler's Symphony No. 3, with the marvelous Jacques Lacombe conducting the New Jersey Symphony Orchestra in its concluding classical concert for the season. (Ruth is an indefatigable Co-chair of the NJSO.) When the last note was sounded, the nearly sold out audience at the New Jersey Performing Arts Center (NJPAC) exploded in a loud and enthusiastic roar of approval. (I am very pleased to see full houses at the NJPAC, where I am a trustee and chair an investment committee with very impressive co-members.) Though the Mahler symphony was composed over 100 years ago, being amidst Saturday night’s large and vocal crowd reminded me that one of the most valuable skills of some of the best investment managers that I have known and studied over the last half century, is to avoid crowds, especially early crowds.

Bond buyers and inflation

Last week bond buyers purchased between $40 to 50 billion dollars of securities, depending on which sources one used. Most of these issues were of high perceived quality and therefore relatively low yields. The yields were below many actuarial assumptions for pension plans, were below endowment fund expectations, and certainly did little to resurrect the retirement capital accounts of investors. Why the rush? The answer may well be that there is too much un-invested money sitting around earning next to nothing. The pressure to “do something” at times becomes unbearable. In the week, we saw the issuers take full advantage of the crowd; including Google raising $3 billion in addition to over $30 billion in cash on its balance sheets. Perhaps the buyers will be rewarded with interest rates dropping further (if that is possible) and therefore pushing bond prices up.

The two largest middle class populations outside of the US are in India and China. Both countries are experiencing reported and less-reported inflation at an accelerating rate. These populations are relatively unschooled in high finance, but are living through an inflationary experience and are acting smartly. Both are buying gold in all forms. In the first quarter of 2011, the purchase of gold by the Chinese was $40 billion, or about the same amount as its weekly bond buying surge. Often ordinary people are more correct than well-schooled experts, and therefore I am expecting an increase in the rate of inflation.

Gold buying is not the only defense against inflation. On Friday I attended the annual Investors’ Day for the Sequoia Fund, a mutual fund that has been held for many years by some of our investment advisory accounts. In discussing inflation, the president of the fund stated that ownership of well-managed corporations that have protected pricing power is an effective inflation-defensive strategy. I tend to agree.

Lack of Historic Perspective by Equity IPO Buyers

LinkedIn recorded a doubling of value on its first day of trading, a modern record. The key facts are: The company had no earnings, and at the initial prices it was selling at eleven times sales. By the end of the first day therefore, it was selling at more than twenty-two times sales. Assuming that full taxes are paid and that the after-tax operating margin is 50%, the potential price/earnings ratio would be a minimum of forty-four times earnings, if there were any earnings. When I was learning security analysis at a trust bank, there was a rule that senior investment management would not accept a terminal P/E valuation in excess of 25x. Further, there are very few companies that have a history of growing operating earnings with low double digit growth rates over a decade. A rare, exceptional company might be able to grow operating earnings in the mid to high teen range over a ten year period. I am not conscious of a company growing operating earnings 20%+ over ten years on a fully taxed basis. History would suggest that the first day closing price for LinkedIn was a function of undisciplined price behavior or aggressive shorting pushing up demand.

Lesson of The Week

Stand up and cheer great performances, but stay away from participating in crowded trades. This principle is applicable to bonds, stocks, or for that matter, anything that trades. Some of the biggest gains in the hedge fund that I manage have come from buying stock after an IPO price ran up, and subsequently collapsed well below the initial price. I doubt that I will buy into LinkedIn soon, (the stock, as distinct from the service). My early training at the bank requires publicly traded securities to have earnings.

Sharing Disciplines
What are the personal disciplines that have kept you out of investment trouble? Please share these disciplines with me via email; letting me know your choice whether to share them with the Blog community or for my use only.


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