Critical Decisions: Successors, Appreciation and Preservation - Weekly Blog # 523

Introduction

The combination of long flights and attendance at the Berkshire Hathaway* Revival meeting has led me to think more prominently about the structure of successful investment processes. I have often said that if one slashes the wrist of a securities analyst (even before they become portfolio managers), a historian will bleed.

I have been thinking about the failure of the conqueror of the ancient world Alexander the Great, whose key lieutenants were for the most part bad successors. In contrast, I compared that result with today’s most profitable company, Apple* and the succession of Tim Cook to the product/service genius Steve Jobs. (This not a prediction as to the future of Apple or its shareholders.) Currently we are in the public succession disclosure phase of the distinctive leaders of two companies: JPMorgan Chase* and the aforementioned Berkshire Hathaway. I believe both successful and less successful command changes should be studied in terms of responsibilities for our families and non-profits we care about.
*Held in client and/or personal portfolios

The Wrong Instincts

I have sat on a number of non-profit boards officially or observed them as their external investment manager. I have noted a number of habits that usually led to long-term sub par results. Choices are made by committee which tends to favor the politically skilled candidates. Frequently it is deemed important that the new leader get along well with the existing staff. Often what is needed for optimum survival  is to either seriously remove staff or materially change their way of thinking and executing. This is particularly true for academic groups where the new person is meant to solve the single biggest short-term problem facing the institution without upsetting too many of the existing “warhorses.”

Another road to failure is setting up a competitive horse race. Not to say that the best person not often wins, but all too often some of the better people leave in disappointment, which weakens the firm even if the best person wins. Unfortunately, we have seen this approach in financial organizations. Just think of the number of CEOs that have come out of GE and a number of leading brokerage firms. The same thing happens with both non-profits as well as families.

Successful Patterns

When Steve Jobs recognized that his deteriorating health would lead to the need for a new leader he chose Tim Cook. He was not a “product guy” like Jobs, but was the master of the supply chain manufacturing and selling all the wonderful new products that were dreamed up by Jobs and his tight design crew. Further, Jobs told his appointed successor not to do things they way he (Jobs) would do them, but the way that made sense for Tim Cook. Under the successor, the shareholders (and I presume the Job’s estate) have seen their assets multiply a number of times. I suspect that Steve Jobs’ thinking was in part shaped by having been fired from Apple in 1985 to avoid taking it into bankruptcy. Luckily he learned a lot with new responsibilities and was better prepared to be Apple’s CEO the second time.   

Selecting Two American Generals

We have benefited from two US Presidents making controversial decisions to lead our Army at critical points. President Abraham Lincoln chose a cashiered Ulysses S. Grant to lead the Union forces through a brutal campaign, first in the Midwest and then the South. Grant who graduated from the US Military Academy at the bottom of his class, accepted the surrender of Robert E. Lee who graduated at the top of his West Point class and is generally believed to have been the best general of the Civil War era. Lincoln’s selection of Grant was key to the eventual Union victory.

When it came to choosing the commanding general for the US-led invasion of Europe, President Franklin Roosevelt turned down the highly respected, most senior Army officer General George Marshall

(later a brilliant Secretary of State) in favor a much younger and junior officer, Dwight Eisenhower. I suspect FDR’s thinking was shaped by the fact that for a number of peacetime years Eisenhower was on the staff of the very difficult, but brilliant General Douglas MacArthur, who not only graduated at the top of his West Point class but also returned to the Academy as superintendent.  I believe that the President felt that if Eisenhower could get along with MacArthur he could work with the difficult British Field Marshal Bernard Montgomery. Being a politician himself, Roosevelt recognized the importance and skills of another politician.

People Skills Part of Asset Allocation

Warren Buffett believes his greatest contribution to the success of Berkshire Hathaway is making major asset allocation judgments. Beyond the required investment skill to make these decisions, he has the ability to “sell” his decision both internally within the firm, and also to his outside audience which he does very well. In looking at these decisions, with the help of Charlie Munger, he uses both capital appreciation and capital preservation strategies in building Berkshire Hathaway for the next generations of owners. While Buffett likes to portray Berkshire as a long-term thinker, he can afford to do that as long as he has a bountiful supply of cash or short-term paper.

With Warren Buffett and Charlie Munger as models, the approach that we recommend to prospective clients is based on our Lipper TIMESPAN Portfolios^®. For illustrative purposes only we have divided an institution’s or individual’s portfolio into four unequal timespan sub-portfolios. Each portfolio is assigned a portion of both capital appreciation and capital preservation securities and strategies which can be modified if conditions and specific needs dictate. The following table is illustrative and can be modified when required:

Lipper TIMESPAN Portfolio®	% Capital Appreciation	% Capital Preservation
Operational (Short-term)	25%	75%
Replenishment (Cyclical)	50%	50%
Endowment (Present lives)	60%	40%
Legacy (Future Lives)	80%	20%

Source: Lipper Advisory Services, Inc.

Please let me know how you would allocate resources for which you feel responsible.

N.B. One of our long-term subscribers who is both an accomplished mathematician and a successful money manager properly called to my attention that I gave the late Stephen Hawking a Nobel Prize that was not awarded to him. Further he reminds me that his theories were never confirmed by measurement. I plead guilty of being in awe of him as a person and the work he did at Caltech.

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A. Michael Lipper, CFA

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Future Winners Found By One Word: Adaptive

Introduction

While securities analysts are essentially statistical historians, fortunes and reputations be they financial, business, political or military are made by change agents. Most of these changes are not self-evident initially to the change agents, but come about through seeing what is and most importantly what isn't obvious. Seeing what isn't is not enough for success. (Many of my security analyst friends are frustrated by their lack of confidence in the stock and bond markets because their valuation metrics are not working. They are not adapting to the markets structures and valuations and may miss out for a time.)

What is needed is a series of actions to create the somewhat poorly defined solution. For most of those that are called brilliantly creative, it has to do with adapting what already exists but re-purposing it for the new challenge. By definition these change agents are future-oriented and not content with merely repeating the past, no matter how cherished the past routes have been.

For lots of reasons, I believe we have entered a period when we will see new approaches to current problems. These approaches will cobble together some of the past elements with new understanding of the implications of technology.

Learning from the Military

The study of war should be about how to conduct new military operations better than the old methods. For many years the American Civil War was the classroom for the German General Staff. They studied the campaigns of Stonewall Jackson and William Tecumseh Sherman in particular. From them they adapted the concepts of maneuver and column movement. They applied these brilliantly during the first and second World Wars in Belgium, France, and Africa.

During the period between the world wars, our own US Maine Corps developed  both the Raiders doctrine and Personnel Landing Craft as well as the use of aircraft for close tactical support for frontline Marines. They were adapting some of what they themselves had studied against indigenous forces and what was present in the era, but would also be needed in the next global conflict.

Whether BREXIT Succeeds or Fails May Depend on Adaptive Approaches

The "Remain" campaign was based on the current economic factors. The "Leave" movement was based on what the English saw and didn't like.  Assuming an unfriendly divorce, the success of Leavers will depend on their ability to find new ways to make their society and economy survive and grow. Much of the Remain pitch is that the City of London, their one square mile financial district, will lose the right to "passport" their deals into the EU. In Saturday's Financial Times, Charles Leadbeater writes an article of five different scenarios for a post BREXIT era. They go from the collapsed City to London becoming the best of all major financial centers. The final one is dependent upon the people involved adapting to the situation with new technology, but in some ways also a throw back to the medieval Hanseatic League of northern, largely German Cities and London.

The Finance Minister of Luxembourg currently is warning the EU not to underestimate the UK. I believe their success will be the Brits’ ability to change the game by adapting some of the better practices and technology from around the world. As a contrarian with lots of time, I would rather be a buyer than a seller now. The new leadership is encouraging. However, as with all adaptations, there is likely to be some mistakes, but the failure to adapt is likely to be worse.

“Equity: The Film”

It is said that men traditionally resist change whereas women by nature are forced to be adaptive to change. One of the major corners of the financial community that has lagged behind the publicly traded investment houses and banks has been the Private Equity shops. Thus I am looking forward to the premier of a new movie entitled "Equity" which is about a private equity shop with a dominant  woman. The financing for the award-winning film was arranged by Candy Straight with twenty-five other professional investment women. We have known Candy since her days of heading acquisitions for a major pharmaceutical firm through a number of private equity shops and as an independent director of several mutual funds. These women are a great example of being able to adapt to difficult and challenging situations.

   

Large Cap Investments

My wife Ruth and I both have had a long term familiarity with the two corporate "Generals,” General Electric and General Motors. As a young analyst, I spent most of one year going through just about all of the major groups within GE. Ruth comes from Detroit and worked for a major auto parts supplier and raised money from the Detroit business community for the local symphony and local public television. Thus both of us have had a long term familiarity with the two "Generals.”

At one point I joked that the two should merge under the title of General Inefficiency. Clearly for many years the Generals lived in their own world and eventually lost earnings power, market share, and pride of place. But today each is in the process of evolving and adapting to both their somewhat reduced condition and also from more modern leaders.

In the past when I saw GE in a fund's portfolio (it was widely held) I treated it as an investment warehouse to store part of the portfolio until better investments could be found. GM couldn't shake the cyclical tag, and was far less owned by mutual funds, but was a comfortable holding for mutual insurance companies and trust banks. Both of the Generals evolved financial subsidiaries that traded on their parents’ credit rating and commercial relationships without outstanding success except as a recognition of their size. Both of the Generals today have evolved to somewhat smaller, but still giant, multinationals that are producing earnings on a regular basis from most of their activities. Both have benefited from adapting numerous of the business practices of overseas leaders.

Taxable Accounts Own Under 30% of US Corporate Stock

One of the characteristics of the US stock market over the last several years is that Large Cap stocks have outperformed the Mid and Smaller Cap stocks in price appreciation but not in earnings growth. Their attraction has been a throw back to the investment warehouse concept which is reinforced by superior liquidity. One of the reasons for the superior liquidity in the face of declining trading desk and floor capital is the shrinking direct participation of taxable individual accounts. In 1965, which was after my year-long research on GE, taxable accounts owned over 80% of US corporate stock. Today it is under 30%. The more, relatively small players in a marketplace, the safer it is for those in the center providing liquidity. Many of  the other Large Caps carry higher price/earnings valuations than the Generals and are equally challenged to find growing revenues. With both the Generals showing some signs of adapting to better business practices and hopefully accounting practices, their relative positions in the Mega Cap world could generate higher relative price appreciation from a historically depressed price level. The main reason that the Generals suffered the prior price declines (and in the case of GM bankruptcy) is their failure to adapt to present and future conditions.

Two Warnings

I have been stressing the need to adapt. This is not to be confused with a need to adopt. The difference is to add and modify one's own principles. Adoption is wholesale acceptance of the adopted views. This may well be the difference between a merger and an acquisition. Too often the second is one where the acquirer takes no prisoners. The acquisition is to do things the way the acquirer wants. A true merger is when both sides adapt to each other's thinking and procedures and there is a melding into a successful marriage. This is the exact opposite of the Broadway show with the title "I Love You, You’re Perfect, Now Change." The key is not capturing but working with.

The second warning is while I am optimistic for long-term investors, I am concerned by what I believe is a consideration that sidelined investors are now coming back into the market. For the first time in at least one year, many of the financial media outlets are celebrating that money is rolling into mutual funds. As usual, it would be useful to dig deeper. The entire gain in assets came from Exchange Traded Funds (ETFs). Most of that money went into a few fixed income ETFs. I believe the bulk of the ETF flow is from trading-oriented organizations. By the way, four of  the largest transaction volumes on the NYSE this week were ETFs. The money going into fixed income products now is unlikely to be long-lasting when interest rates start to rise. Thus I am warning that the inflow is likely to be found to be short-term rather than long-term investors.

Question of the Week:

What new approaches have you adapted to?

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All Rights Reserved.
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Additional Views on US Energy Independence

Should the US pursue a policy of  energy independence?

Today I am continuing a discussion began in last week’s blog about the economics of  international energy policies.  I offered opinions about these topics prompting a response from my long-time friend and adviser, Dr. Philip M. Neches,  the founder of Teradata, who has spent a great deal of time studying the Energy sector.  Phil Neches received his BS, MS, and PhD from the California Institute of Technology;  he is a successful entrepreneur, writes a thoughtful blog and sits with me as a trustee of  Caltech. 

Last week a portion of my blog explored an Adam Smith-inspired hypothesis that would have the US buy up and deplete as much of the world’s oil as possible, using its own production and reserves for long-term international competitive advantage.  Berkshire-Hathaway’s Charlie Munger, among others, have also discussed this approach.

Oil pricing as a factor

Phil Neches began his response by indicating that he thinks my analysis of oil did not take price sufficiently into account.  He writes, “Yes, the US depends less on imported oil than major economic competitors, but that matters only in the extreme.  In the more ordinary course of business, it will take several more decades of consumption for oil to actually become scarce,  and, as you point out, that can be stretched out by more efficient use.”

He continues, “The short term issue with pricing is not as much about the ultimate depletion of world oil reserves but by the imbalance between demand, which can shift quickly with economic circumstances, and supply, which can only change slowly through expensive development of fields, refining capacity, and transport. Bad actors can make quick changes in supply, and this causes the risk perceived, correctly I think, by the general public and politicians of all stripes.”

US Strategic Petroleum Reserve

Last week I buffered my position with the fact that the US Strategic Petroleum Reserve provided some solace for future emergencies.  Phil offered an offsetting  point I had not mentioned, that today’s military depends upon the civilian economy much more than in the past.  As Phil states, “If the civilian economy is crippled, the military may still be able to operate, but will be far less effective.”

Natural gas

I am mostly in agreement with Phil when he writes that “The most obvious strategy for the US is to encourage substitution of natural gas for oil and coal.”   He continues,  “the biggest win is in electricity generation, for a number of reasons: 

 

First, it would permit early retirement of the dirtiest coal burning plants.   From a Pareto analysis standpoint, this is the best thing we could do to reduce not only carbon emissions, but other pollutants.

Second, gas-fired plants can be sited closer to loads, stretching out the investment in the distribution network.  This is important because there is more capital tied up in distribution networks than in generating capacity.

Third, to the extent that people adopt electric vehicles (either plug-in hybrids or all-electrics), then demand from the transport sector can shift away from oil.”

My thanks to Phil Neches for his additions to this conversation

Investment implications

Careful long-term focused investments should be considered to take advantage of the transportation of oil, gas and coal. The use of energy will go up, adjusting for the cyclically of the global economy. As long as the sources of energy are distant to its users, energy in some form will have to be transported. In the intermediate time period that would include ocean-borne oil, gas and coal. In addition, land-based pipelines and railroads will still have good payloads. I suspect that these thoughts are behind the disproportionate current and future capital expenditures in these areas by Berkshire Hathaway* and other large capital investors. Currently many of these stocks are down from recent peaks because the level of shipments and prices are down. I cannot accurately predict when they will go up, but I believe they will as the world recovers and we move toward rational energy independence.

Disclosure: I personally own a position in Berkshire Hathaway, as does the private financial services fund that I manage.

Historical context

In the United States we celebrate Memorial Day on Monday, May 28^th.  Officially the holiday was started to recognize the death of so many Union (Northern) forces in the Civil War, which some still call the War Between the States. Over time the holiday was combined with a similar day of remembrance for the fallen Confederate soldiers.  For the US, the Civil War was responsible for more total deaths than any war before or since.  In addition to the many domestic causes of the American Civil War, economic forces, particularly international trade, played an incendiary role. As European harmony deteriorates, this holiday weekend I am reminded of the curse of one citizen/nation fighting another on the basis of economic interests and tariffs.

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