Investment Lessons from Berkshire Hathaway’s Meeting

We have just finished attending the annual gathering of Berkshire Hathaway. My wife and one of my sons joined me for this, in effect, convention of Warren Buffet and Charlie Munger disciples. While the five and one half hour question and answer period was meant to be focused on Berkshire itself, many of the comments could apply to how I manage money and perhaps a number of others who are managers and/or professional personal investors. (I would be happy to communicate with you my personal views on the stock which is owned in my private financial services fund as well as my personal account, if asked.)

The following are phrases and sentences from my notes of the meeting:

Personal rules

-Opportunity costs matter.

-Don't make decisions when tired.

-Stay rational by avoiding the applause of Wall Street, don't become envious.

-You must love something to do well at it (intensity of effort).

-Finding new investments/products is exciting.

-Build on what you know.

-Keep learning, the game of life is everlasting learning.

-You won't win every skirmish.

-If the company does not have an edge then don't play.

-If you have doubts, forget it.

My reaction to these rules is that many of these we have heard before from the two master investors. This time the emphasis on opportunity cost is new. What they are suggesting is that every new purchase needs to be viewed against other opportunities; both within their existing portfolios and other potential buys. In effect, they are bringing forward the concept of relative attractiveness in real world situations as distinct from whether something is attractive regardless of alternatives. The personal rules also suggest their defining discipline that has kept them out of most investment troubles over the last fifty years. They have a broader set of knowledge and senior contacts than most other investment managers and I have. Nevertheless, we try to stay within our areas of knowledge and hopefully competence.

Bubbles

-People reevaluate very fast.

-Capital and the willingness to commit quickly during panics are critical, panics will happen again.

-The future bubbles won't be led by the banks.

-During the building of a bubble, the skeptics look like idiots.

-People get fearful and greedy en masse but confidence returns singularly.

-Secured options now with low rates look unsecured.

-You should always want to accept options, but not give them.  

In looking at Berkshire’s great record, one sees that down markets play a clear role in its long-term superior results. First, because of its perceived quality bias its publicly traded investments and many of its private investments go down less than its peers and in most cases the market. Further, if the decline is the result of a collapsing bubble, Berkshire has been successfully opportunistic and quick to offer to rescue sound businesses that are temporarily cutoff from other capital sources. In exchange for very favorable current income with a “kicker,” the rescued company gets a banner approval from Warren Buffet which is quite reassuring in periods of panics. The ability to perform the rescue at very high current and potential rates of return comes from the rapid approval process and the existence of Berkshire Hathaway’s cash pile. To some degree in putting its winnings in perspective, one should recognize the opportunity costs of preserving cash supply in good times for use during crises. Berkshire has a become a skilled fireman in bringing raging fires under control.   

Stock investing

-Good selection process is not just filling out the boxes.

-Likely to do relatively better in down years.

-Pay up for good businesses.

-It is easier to buy stocks and companies than to sell them.

-There are a lot of value buyers as competitors now.

-Massive derivative books should not be insured by the country.

-Buy stocks as if you were buying the business.

-Own good businesses, but don't pay too much.

-Both Buffett and Munger failed as short sellers.

-Modern acquisition prices are not cheap, but the market can offer some bargains.

-With small amounts of capital look at small caps.

Buffett and Munger are champions of selecting the individual reality about companies and stocks that makes the targeted investment different from others in the same “labeled” group; e.g., food stocks or commercial banks, etc. Their analysis focuses on the differences between what they are looking at and the competition at very current prices. Their bias toward quality helps during declines. They are very conscious of how their present size effectively gets significant impacts from small investments. Like many successful long-term investors they have not been able to prosper through short selling or the use of derivatives outside of hedging. They don’t appear to have long-term targets, but recognize quickly when the stock market gives them an opportunity at an attractive price.

Successful acquisitions

-The key to successful acquisition of clients and companies is getting them onboard through self-selection.

-Most successful businesses are not truly easy to understand or operate.

-Size can be an advantage in down markets.

-Capital allocation is critical to big successes.

-It is easier to buy stocks and companies than to sell them.

-Building by book value is cheaper and may be sounder than acquisitions.

-If you want to be good partners, treat subsidiaries as if the parent was a sub and the acquired was the subsidiary.

-Invest with an idea of what something will look like in 5-10 years.

Since Berkshire’s long-term progress over the last several years of a relatively flat stock market is from significant earnings advances of companies that it owns outright or are a majority holder, it needs to focus on what makes a good acquisition for the company. Personally, I have been both an acquirer and a seller of companies as well as a consultant to parties in these kinds of trades. I recognize that Berkshire, in general has not only made good acquisitions, but much more importantly it has managed with a light touch the purchases of good operations and kept them producing and growing. Berkshire’s capital gathering and allocation skills are among the best acquirers. Most others could learn from them.
 
Analysis

-Focus on operating earnings, not accounting-published earnings.

-As a yardstick to measure Berkshire and other companies, intrinsic value is better, but a more difficult measure to determine than the published accounting book value.

-Imperfect accounting in mergers/acquisitions and changing accounting/data systems can leave holes.

-Math does not disclose competitive advantage.

-Buy businesses not just stocks.

Berkshire Hathaway is very conscious of what accounting statements do not reveal, particularly competitive advantages. Also it is aware that under corporate tax accounting, various assets of “S” corporation and LLC books could look quite different under “C” corporation tax returns. Further, Berkshire knows where to look for potential problems with the assembly of numbers from recent merger activities or the installation of new accounting and tax systems. Berkshire possesses a level of rapid expertise in examining potential acquisitions that most other potential buyers do not bring to the party. These skills are worth a great deal that is not recognized in Berkshire’s book value, but should be acknowledged in an analyst's estimate of intrinsic value.

I would happy to discuss any of these thoughts individually.

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Are the New York Jets an Answer to the Bubble Of Pessimism?

This week’s communication was purposely delayed as I wanted to watch the football game between the New England Patriots and the New York Jets. As the market would be closed on the day following the game due to the celebration of the life of Martin Luther King Jr., I felt the delay would not hurt anyone’s trading procedures.

For the international members of this community let me point out that the New England Patriots are generally viewed as the single best team in professional football. Most observers also believe that their coach is the single best coach in professional football. Prior to the game, I was discussing the match-up with a close associate who lives a few miles from Foxborough Stadium (where the game was played); I was assured that the locals were convinced that the New England Patriots would once again win. The New York Jets home base is in New Jersey, and their practice field is supported by the hospital group whose investment committee I chair. Thus, I am a supporter of the Jets. My reaction to my Massachusetts associate before the game was that I would be happy if the score would be closer than the 45-3 shellacking that the Patriots delivered to the Jets in their previous game in December.

The reason I link last night’s game to the investment game is that there were a number of lessons to be learned. I found it curious that when these two competitive teams met last night the gross total of points achieved was very similar to their last meet. In the December game there were 48 total points scored. In last night's game there were 49. The big difference was the distribution. In the second game the team with the fewer victories to that point scored 28 points, while the perceived better team scored only 21. One of the statistical lessons from this comparison is that the distribution of numbers within a numbers’ set is extremely important, even if the numbers’ set appears to be identical to a past experience. The second lesson from this game is learned from how the New York Jets changed their game. The Jets introduced four new defensive schemes which confused and/or delayed the superior quarterback of the Patriots. The lesson from this tactic is that defense is critical not only in football, but also in investing (i.e. don’t lose money), and also that competitors learn to come up with new solutions for their problems.

My pessimism as to the outcome of the game last night is instructive and similar to my outlook on the current state of the markets. The initial pessimism about the game was based on a lot of the aforementioned facts, but similarly in reading about the long-term outlook for investing I was impressed by the litany of unsolved problems that were identified by many as a follow-up to their near-term bullishness.

Bubble of Pessimism

The much-used term “bubble” identifies a series of market disruptions that veer from an extreme of high money-making to an even bigger period of money-losing. The current bubble of pessimism is international (not only the US) and rests on five related elements.

• The first element is the absence of jobs for those who want to work.
  
  
• The second element is deficits; both in terms of governments (societies) spending more than they are collecting in taxes; as well as a banking system that has loaned more money out than it has appropriate collateral. To correct these two components of deficits there is a strident call by some to raise taxes. The problem is those who pay taxes are increasingly a minority within the society and these tax payers are the same people providing capital to create jobs.
  
  
• The third element is the value of paper money. Fiat currencies (currencies that are not backed by hard assets) are dependent on others seeing that a currency is a store of value. With the escalating rise in the price of commodities in general (and specifically in gold), some in the market place are questioning the value of the currencies.
  
  
• Then comes the fourth element: inflation. Some of this is caused by the aforementioned concern for currencies, but there are other contributors such as the scarcity of newly available natural resources as well as the US government’s attempt to induce more inflation into our economy through the manipulation being caused by quantitative easing.
  
  
• The fifth and final element in the bubble is deflation. The fear here is that lower prices will not only affect the prior identified inflation, but will cause various businesses to shut down as they cannot re-capture enough income to pay their bills.

This is a very distressing list.

The Other Side of the Coins

Just as the Jets surprised the Patriots as well as their own fans, some good things can happen.

• First, in those countries that restrict immigration (one needs to include the U.S. in this list), the absence of new immigrant employees, and to some degree their families, is restricting business and individual consumers from the options of buying goods and services at lower prices. One of the reasons that some point out that the U.S. will have a better future than “Old Europe,” is that we have some immigration and often do a reasonable job of assimilating these newcomers. The developed world (with the exception of the US) is now producing future wage earners in a smaller number than the recent past which will be compounded by those who will soon retire. Further, at the intellectual upper-end of the spectrum, the U.S. has some of the best universities in the world. But as mentioned in previous blogs, our students are not among the leaders in all subjects, specifically science, reading and math. Currently our prime universities are attracting brilliant minds as students (and where possible, faculty) but due to limited visa opportunities, these brilliant minds are not staying here. I am hopeful that the change in focus on the part of the Administration and members of the House of Representatives is such that we will start to untie the Gordian Knot of Immigration. I believe our society would be better off having people who want to work rather than carrying too many of those that are restricting their own job opportunities for one reason or another.
  
  
• The next positive element is technology, which for the most part develops labor-saving devices and procedures that allow capital to be re-deployed into higher returns, both here and overseas. From time to time there will be important technological breakthroughs that will solve, or at least ameliorate many of life’s problems. Not only will these be found through our health care innovations, but they will also aid in improving our deteriorating infrastructure and education. Currently, both use too much labor to produce mediocre results.
  
  
• Another element that makes me caution the long-term is the increase in the level of consumption in what we used to call the “developing world” and hopefully now will call “clients.” As these new world consumers want more and better products and services, they should increasingly become our clients.
  
  
• The final element is what we saw the Jets do to the Patriots. The Jets came up with new ways to play aggressive defense while the Patriots were slow to adapt. As the members of this blog community have learned, I focus an inordinate amount of time on the financial services industries, in part because I manage portfolios (both personal and for others) that invest in financial services. While we can debate the wisdom of the Dodd Frank Bill and the Credit Card Act, for the moment they are the law. I find that it is encouraging that two of our leading financial services companies, Goldman Sachs and J.P. Morgan Chase have already instituted new programs that will over time, replace threatened revenues, while also enlarging their customer set. Jefferies & Company is also filling a perceived void in the global middle markets.

Conclusions

Just as I was surprised on the upside by the Jets’ victory, I suggest that we should not swallow all of the bubble of pessimism, but rather we should use it to develop new ways to make money. While not cheap by historic standards, the current market is not terribly expensive either; leaving room in the long run for much higher prices.

Onto the next game.
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