Friday, June 24, 2011

Buffett: Waiting For The Fat Pitch - Berkshire Shareholder Letter Highlights

From Warren Buffett's 1997 Berkshire Hathaway (BRKashareholder letter:

"In his book The Science of Hitting, Ted explains that he carved the strike zone into 77 cells, each the size of a baseball. Swinging only at balls in his 'best' cell, he knew, would allow him to bat .400; reaching for balls in his "worst" spot, the low outside corner of the strike zone, would reduce him to .230. In other words, waiting for the fat pitch would mean a trip to the Hall of Fame; swinging indiscriminately would mean a ticket to the minors.

If they are in the strike zone at all, the business 'pitches' we now see are just catching the lower outside corner. If we swing, we will be locked into low returns. But if we let all of today's balls go by, there can be no assurance that the next ones we see will be more to our liking. Perhaps the attractive prices of the past were the aberrations, not the full prices of today. Unlike Ted, we can't be called out if we resist three pitches that are barely in the strike zone; nevertheless, just standing there, day after day, with my bat on my shoulder is not my idea of fun."

When the above was written, the party that ultimately led to the tech bubble era valuations* had already begun in the equity markets.

Overvaluation, in some cases extreme, became the norm.

A field day for those speculating on price action yet not so amusing for those in the business of estimating current value, likely future value, and trying to buy things at a sufficient discount.

So, at the time, marketable securities became increasingly decoupled from the economic forces that determine value. The financial equivalent of ignoring Sir Isaac Newton's law of universal gravitation.

Now, gravity and, more specifically, a so-called zero gravity flight provides a useful way to think about what happens in markets from time to time.

For a brief period measured in 20 or 30 seconds, a zero gravity flight can, in fact, simulate weightlessness and make it seem to passengers like there's no gravity. Yet, while a zero gravity flight can make it seem there are negligible gravitational forces at work for a short time, eventually the plane will leave the zero gravity phase -- the parabolic arc -- and the fact that gravity is still very much there becomes front and center again to the passengers.

An easy to understand temporary illusion.

A similarly easy to understand temporary illusion happened in the late 1990s in the equity markets.

In the long run it is intrinsic value** -- the discounted value of all cash that can be taken out of a business during its remaining life -- that anchors market prices the same way gravity keeps us firmly planted on terra firma.

In the long run.

In the short-to-intermediate run it's a very different story.

Markets do occasionally enter a period analogous to a zero gravity flight. It may be for a period greater than 20-30 seconds, but basically that's what happens. Consider the late 1990s. For several years the passengers (i.e. market participants) were stuck in the zero gravity phase of the financial flight, where it seemed that the market's equivalent to gravity (i.e. intrinsic value) was no longer at work, but some made the mistake of thinking it somehow was not just an illusion.

The zero gravity phase for the equity markets ended when the dot com bubble burst.

So, in 1997, market prices had already begun decoupling from economic reality. After a while enough market participants believed the illusion was real (others saw it for what it was but likely believed they'd be able to find a chair when the music stopped). It was not a fun time if, like Buffett, buying shares of a good business (or, in his case, sometimes, an entire business) at a meaningful discount to their intrinsic value was your game.

Even though market prices got even sillier a few years later (the decoupled getting even more decoupled), it was already difficult in 1997 to find shares of a good business selling at prices that offered a substantial margin of safety to the investor.

Today, the investing landscape is very different in my view. On the surface, the market as a whole is not exceptionally cheap.

Yet, below that surface I happen to think we find ourselves in an investing universe that, while not containing an overwhelming number of fat pitches, there's certainly enough to occasionally take the bat off the shoulder.

Adam

Long BRKb

* I've said previously, it was not just the tech and internet stocks though that is certainly where valuations became the most extreme.
** From the Berkshire owner's manual"Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life." Of course, there is no perfect estimate of what the cash that can be taken out of a business during its remaining life will be. Yet, despite the zero gravity illusion -- or, at least, the equity markets equivalent -- stock prices should to an extent be anchored by intrinsic value within some plausible range. Still, expect the alternately manic-then-depressed nature of markets to reinforce the illusion. Short run -- and even longer run -- price action will sometimes completely decouple from the intrinsic value anchor.
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