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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