Four Lessons Discussed - Weekly Blog # 877

 

 

Mike Lipper’s Monday Morning Musings

 

Four Lessons Discussed

 

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018

 

 Farmers’ Experience Led to the Crash

Is 1930 a preview of 202x? To set the stage, the 1920s were a period of transition and economic expansion. America and most of the industrial world enjoyed meaningful economic progress spurred on by the encouragement of increased debt. Governments, companies, individuals, and farmers used the resources of others to leverage their assets with increasing debt, fulfilling their perceived needs at ever increasing rates. The lessons of the 50-years before WWI were distant memories.

 

Due to WWI mobilization, women entered the workforce in increased numbers. The returning military found farm work too hard and too poorly paid on the farms. Financial communities, which had extensive experience with debt and leverage, found vast new markets for the financial skills of banks and others. Thus, the missing manpower was replaced by expensive machines and chemicals, which led to farmers owning leveraged machines and farms.

 

The age-old problem with leverage is the cost-price spread abruptly narrows. In a world becoming increasingly more global, international trade becomes the fulcrum-point of the fluctuating cost-price spread. To protect those in the middle from price swings, tariffs and other restrictive measures were introduced.

The US consumer desired ever-increasing amounts of food, with much of it imported from lower cost countries. To protect home-grown crops, additional costs and restrictions were placed on imports. Exporting countries fought back by lowering their prices to a point where domestically produced products could not compete effectively. Consequently, domestic farmers got their elected politicians to impose tariffs on imports, like the Smoot-Hawley tariff that President Hoover was reluctant to do. (It was repealed three years later) Other nations reacted by imposing their own tariffs on US exports, which was a contributing cause for WWII. 

 

What will be the impact of the proposed Reciprocal Tariffs being proposed? Despite what is being said, it seems unlikely consumers will avoid some or more of the cost.

 

Learning from Uncle Warren

This weekend Berkshire Hathaway (*) published its results for the 4th quarter and all of 2024, along with a well thought out discussion. The company has four main revenue sources for the heirs of its shareholders. Berkshire has total or partial ownership of over 180 private companies and a smaller but better-known portfolio of quite large publicly traded companies. They also have an increasingly large portfolio of short-term US Treasuries, which increase in value as interest rates rise.

 

The difference between what their insurance companies charge and their eventual payout is called a “float”. In the most current period all earnings asset categories rose, except for the holdings of the publicly owned securities which declined because of sales. The total portfolio rose and is selling very close to its all-time high. Considering the company announced it is being managed for the benefit of today’s shareholder heirs; it is extremely appropriate to occasionally reduce its near-term market risks. (It is worth noting, the remaining two lessons in this blog suggest caution is warranted.)

(*) Owned in Personal and Client accounts

 

The Leading Mutual Funds Suggest US Risk

Each week I look at over 1500 SEC registered mutual funds, as well as many more in the global world. Usually, a number of different drivers describe the leaders of the week.

 

The list below shows the investment objective assigned to the fund:

Precious Metals Equity           21.04%

Commodities Precious Metals      11.86

International Large-Cap Value     8.60

International Mid-Cap Value       8.54

Commodities Base Metals           8.34

International Large-Cap Growth    8.24

Commodities Agriculture           8.15

Warren Buffet, among others, is concerned that the US government may cause the value of the US dollar to drop.

The year-to-date winners are not investing in the US.

 

“Debt Has Always Been the Ruin of Great Powers. Is the U.S. Next?”

 Above is the title of Niall Ferguson’s article in Saturday’s Wall Street Journal where he introduces Ferguson’s Law, which was crafted in 1767. The law states “that any great power that spends more on debt service than on defense risks ceasing to be a great power.” According to the author, debt service includes repayment of debt and defense includes all costs to maintain the military. The US has just passed this milestone, but it would take an extended period to fundamentally break the Ferguson Law.

 

Working Conclusion

Be careful and share your thoughts, particularly if you disagree.

 

 

 

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Mike Lipper's Blog: Recognizing Change as it Happens - Weekly Blog # 876

Mike Lipper's Blog: A Rush to the 1930s - Weekly Blog # 875

Mike Lipper's Blog: More Evidence of New Era - Weekly Blog # 874

 

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Lessons From Warren Buffett - Weekly Blog # 852

 

         

Mike Lipper’s Monday Morning Musings

 

Lessons From Warren Buffett

 

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018

 

 (Many subscribers will receive this blog on the regular Monday schedule, but some distributors are taking Monday off, so you may not see this blog until Tuesday.)

 

 

As Often the Case, Media and Other Pundits Missed the Opportunity to Learn 

The August 29th New York Times headline stated, “Berkshire Hathaway Hits $1Trillion in Market Value”. However, the headline was essentially a current events piece, which missed an opportunity to plum Mr. Buffett’s actions. In so doing, they learned no lessons from his current and historic activities derived from an extremely successful professional investment career. 

 

Caution: Bias at Work 

Berkshire Hathaway is the largest position in my personal accounts. Perhaps more significantly, I share a responsibility with Mr. Buffett, I manage money for personal accounts. We are not managing money for our own benefit, but for our heirs. In my case, it begins with starting to care about the fourth generation. 

 

This orientation leads to largely investing strategically, which means positions are permanent unless conditions change materially. This desire separates Mr. Buffett and me from most professional/individual investors who are more focused on tactical approaches. Most investors react to sell signals, while we focus on disappointments as a need to re-underwrite. We hope to add to our holdings at cheaper prices while extending our holding period. 

 

Strategic Diversification 

Changes occur at different times for different opportunities, making it wise to take advantage of changes with different tools. While Buffet is always looking for lasting value, he has found a way to take advantage of these situations with different tools.

  

Berkshire was initially mostly a buyer of cheap stocks selling below book value, which worked reasonably well coming out of the depression. The focus changed to buying good companies at fair prices when Charley Munger came on the scene. As fairly priced securities became scarce and Berkshire’s assets grew, cheap assets were to be found in the private assets of whole companies. After a few mistakes they learned how to pick winners.

 

For many years the wholly owned companies were larger than the publicly owned and publicly traded companies. Within this collection of companies there were a few insurance companies, including GEICO and other casualty insurance companies. The primary attractiveness of these companies was “the float”, allowing for the use of client cash before it was needed to meet claims. The insurance assets grew, and they hired very talented people to underwrite very large risks. Most casualty insurers were risk adverse, but Berkshire looked at insurance risks as opportunities at very high rates. On balance the rates were larger than the risks, which allowed for large, long-term “floats”. The final, or perhaps the first type of asset was cash. 

 

Cash, the Intermediate Asset 

Most investors treat cash as the ultimate reserve asset, but not Warren Buffett. After segregating Berkshire’s $100 billion in US Treasuries, he devoted the remaining cash pile to acquisitions. Buffet recently sold 50% of his Apple stock and enough of his Bank of America stock to drive it below 5% of its outstanding stock value. He did not buy any of his own stock with the proceeds. (I suspect he has converted more of his assets to cash.) 

 

I have stated that these moves are the most “bullish” indicators I have seen. I don’t know whether this cash will be used for the acquisition of a private company or a publicly traded stock. I have been told he has made some offers, but he has been outbid. When the market breaks, his cash will become more valuable. 

 

Some other Buffet lessons are useful in building a picture of how his mind works: 

• Losing is part of winning 
• Cash is not king 
• It is okay to change 
• Buy businesses, not CEOs 
• Don’t buy art as an investment, buy it for pleasure 
• There is no such thing as growth or value stocks as Wall Street generally portrays as contrasting asset classes. Growth stock is part of the value equation. 

 

 

Question: Are you utilizing any of Buffett’s lessons? Which do you disagree with? 

 

 

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Mike Lipper's Blog: Understand Numbers Before Using - Weekly Blog # 851

Mike Lipper's Blog: The Strategic Art of Strategic Selling - Weekly Blog # 850

Mike Lipper's Blog: Investment Second Derivative: Motivation - Weekly Blog # 849

 

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Lessons from Warren Buffett and an Italian Monk to 2nd Generations of Wealth - Weekly Blog # 565

Mike Lipper’s Monday Morning Musings

Lessons from Warren Buffett and an Italian Monk to 2nd Generations of Wealth

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

                                                               

One of the consistent career risks for long-term successful investment managers is dealing with the inheritors of sizeable accounts portfolios at the instant of perceived under-expected performance. Throughout their lives the inheritors have heard about the investment successes of their seniors’ advisors and investment vehicles. They take for granted it will mechanically continue for them. They do not understand that all investments, like all of life, involves risks. There are no absolute guarantees under any condition. Investments are packages of risks and rewards over numerous cyclical time periods and need to be understood.

Lessons from Warren:
We regularly write about Warren Buffett and the incomparable Charlie Munger concerning their investment vehicle, Berkshire Hathaway. We do this not because it has been a successful investment for myself personally and the holders of our financial services portfolio, but because of the valuable lessons that can be gleaned from these two remarkable investors in both words and actions.

Let me put their record into perspective. According to the latest issue of the Financial Analysts Journal, if Berkshire Hathaway had been a mutual fund over the last 40 years it would have beaten 100% of the competition. Even for the last ten years, a more difficult period in view of their size, they would have finished 11th, beating 99.7% of their perceived peers. That is the good news, now the bad news. On Saturday they issued their results for the fourth quarter of 2018, reporting a net loss on investments of $25 billion.

This is not the first time they have reported a loss. The original source of their name could not be turned around and was liquidated. Additionally, there were losses in a Baltimore department store and losses in airline common stocks, among others. Why do we own the stock today when on Monday it is quite likely there will be many commentators bewailing the loss of investment skills of Buffett and Munger. Those critics do not appreciate the evolution of the company and what has been built for future investors.

The first vehicle was the very successful Buffet Partnership, a hedge fund. At the time, when too many publicly traded stocks were trading above their private market value, they began to buy control and at times  a 100% ownership interest in the operating companies. This was in addition to their stock and bond portfolio and led to the acquisition of various insurance companies. For Berkshire, the attraction of these casualty insurers was their sizeable “float”, the difference between the premiums received and the claims paid. Today this is the largest source of leverage for the firm. (A few companies do this, but not as successfully as Berkshire.) Further, the use of the float is not taxed until the claims are paid, which may take many years and creates another form of leverage.

Frequently, during periods of financial distress, good companies with too much debt have been forced to seek additional capital to protect their reputation and credit rating. In the past these companies were willing to pay above market interest rates, pay preferred dividends, and issue options to Berkshire in order to benefit not only from their cash but also from their perceived endorsement. I call this reputational leverage. Finally, it is important to recognize that due to the large tax credits earned by its railroad and energy ownership, Berkshire can shield the operating earnings of any tax paying private companies it acquires. Berkshire also benefits when their publicly traded investments buy back stock and raise cash dividends. For example, over time they have purchased 12.6% of American Express, but currently own 17.9% of the company due to stock repurchases.

In the classic sense Berkshire is not a large user of stock margin loans. From a credit perspective it is not overly exposed to changes in the level of interest rates. In this light its 3rd largest public stock holding is an almost $19 Billion position in Coca-Cola, which is unlikely to move much if interest rates take a sudden jump.

What are they creating? Recognize that much of the stock is owned by people senior in age that have not benefited from cash dividends all these years. I believe to an important degree the 88 and 95-year-old owners are building something for their heirs. When they are no longer leading the company, they will have completed the transition from a capital appreciation vehicle to more of a capital preservation vehicle producing a regular stream of dividends and buybacks. This is not to say, despite Mr. Buffett’s expressed political views, that he is any less than optimistic as to the growth of the US and much of the rest of the world. (This contrasts with a report that the wealthy Chinese have become increasingly pessimistic, with some moving their wealth overseas and some thinking about physically moving as well.)

A Missing Nobel Prize
Getting back to helping the second generation of wealth, there was something missing from their schooling which could have led to their real education. What I am suggesting is that in their study of either history or philosophy there was no mention of an Italian Monk. Luca Pacioli, a Franciscan friar, published the first book describing double entry accounting 1494. Earlier examples occurred in Korea and Egypt centuries before. What they recognized was that every entry created an equal and opposite entry on a proper set of financials. Thus, the original size of an asset would need to be offset by debt or changes in equity. In modern language, it is like saying that there is no such thing as a free lunch. This recognition deserves a Nobel Prize, for it would make us think through all relationships and flows of money. I believe it was Sir Isaac Newton or some other ancient scientist who stated that every action has an equal and opposite reaction. An understanding of this dual nature of human and physical reality could help all those who believe in one-way streets.

What is Happening Now?
Using my familiar lens of looking at the markets through mutual fund performance averages. For the year-to-date through last Thursday night Small-Cap funds were the leader, with an average gain of +13.08%. The best of the best were the Small-Cap Growth funds +17.62%. Part of the gain was due to global science & tech funds, but an equally important part were the gains resulting from the recovery after the fourth quarter decline. I believe the decline was the result of a liquidity squeeze on traders and dealers, rather than the consequence of fundamental concerns. In the weekly WSJ list of 72 price changes for indices of stocks, bonds, ETFs, currencies, and commodities, only 9 fell, an unusually low number.

With many funds and stocks displaying double digit gains, the idea of a mid-single digit gain for the year could be wrong. Being wrong does not bother me much unless it is very wrong. Let me suggest a warning level for the much expected overly enthusiastic top. If the rest of 2019 produces a return, that when averaged with 2017 and 2018 is substantially above the corporate return on equity, watch out.


  
Did you miss my past few blogs? Click one of the links below to read.

https://mikelipper.blogspot.com/2019/02/could-biggest-risk-be-confirmation-bias.html

https://mikelipper.blogspot.com/2019/02/some-retire-while-others-sense.html

https://mikelipper.blogspot.com/2019/02/should-reputations-have-sell-date.html



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I am Happy I Bought More Berkshire Hathaway

Introduction

I do not have buyer's remorse from adding more shares of Berkshire Hathaway (NYSE: BRK-A), currently priced at about $120,000 per share, to my private financial services fund. At the end of each year I make an effort to invest any spare cash that has accumulated in this portfolio; Berkshire was one of the three stocks I purchased at that time.

The ‘Buffett Discount’

For the last few years, along with my wife, one of my sons and good friends, I have attended the Berkshire Hathaway shareholder meeting in Omaha, one of the world’s largest such gatherings. After last year’s meeting, I wrote about the “Buffett Discount” in my blog entitled Observations from Omaha. Normally, stock prices pay a premium for a history of successful management, sometimes too much. In my opinion, last year the reverse was true. The uncertainties as to who would, in time, replace Warren Buffett and Charlie Munger, weighed on the price of the shares. This was a concern for a number of years, but last year became a headline event when the presumed CEO replacement left the company under trying circumstances.

The last Saturday in February is the usual time that Berkshire publishes its annual report, including a much anticipated letter from Mr. Buffett. On Saturday, like many portfolio managers and other investors, I devoted a number of hours poring over the document. While there was additional, welcome, detail on the progress of the company, there was very little of new information that would have changed my mind at year end, when I decided to increase our investment. What was news was the disclosure that the next CEO and two backups is known to the board, but not yet revealed to the other shareholders. For some investors this may close the Buffett discount, but I was confident that it would happen one way or another relatively soon.

My rationale for buying more

Our most recent purchase of BRK-A is already up 4.6%. (I mention this to our blog community and fellow shareholders only because we bought in the midst of what was considered by many as a troubling stock market.) Below is a brief outline of my thinking.

1. We bought at a small (15%) premium to a very much understated book value. The company itself has a policy of only paying 110% of book when buying back stock. The book value of Berkshire's operating assets is essentially its purchase price, but after acquisition earnings. As many of these acquisitions were made years ago and at bargain prices, I am guessing a multiple of book is a more appropriate measure. (This might suggest that the return on investment would be lower, based on the higher augmented book value.)
   
   
2. The Buffett discount mentioned in my prior Berkshire blog is being addressed. There is now an undisclosed CEO, with two backups in reserve. In addition, two value-focused investment managers have been hired.
   
   
3. The five largest operating subsidiaries are reporting record operating income.
   
   
4. “Float” production remains ample, aided by nine years of underwriting profits (even if there is an occasional loss year).
   
   
5. Recognition of past mistakes is acknowledged by management, both in terms of acquisitions and portfolio decisions. This is comforting compared with many CEOs and portfolio managers.
   
   
6. Berkshire benefits from others providing leverage for its regulated activities. Operationally, Berkshire is leveraged to housing, which appears to be getting better.
   
   
7. As the company is primarily US-based, after much of its US business is improving, our multi-year outlook is encouraging.
   
   
8. Averaging up at a lower valuation is generally a good thing.
   

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