Tuesday, May 26, 2015

Berkshire's Architect

Last year, at the 2014 Daily Journal (DJCO) annual meeting, Charlie Munger said the following:*

Berkshire has been a huge exception. In this year's annual report Warren [Buffett] intends to deal extensively with: Why did it happen at Berkshire? Will it continue? We've reached a size and the record is interesting enough that those are very important questions.

From 1965 though the end of 2014, the share price of Berkshire Hathaway (BRKa) has increased at an annualized rate of 21.6%.

That rate of return would have turned an initial $ 10,000 investment into over $ 180 million over those fifty years. Importantly, Berkshire's long-term returns were driven by increases to per share intrinsic business value. Speculative (and even nonsensical) prices can persist for a period of time but, ultimately, prices will roughly track changes in business value on a per share basis.
(Of course, at Berkshire's present size, future returns have little to no chance of coming anywhere close to that rate of return. That reality doesn't negate what can be learned and applied.)

This year, consistent with what Munger said last year and to recognize the fifty years that have passed since first taking charge of Berkshire, Warren Buffett wrote a special letter to reflect on the company's past and to offer some thoughts on the next fifty years.**

From Buffett's letter:

"My cigar-butt strategy worked very well while I was managing small sums. Indeed, the many dozens of free puffs I obtained in the 1950s made that decade by far the best of my life for both relative and absolute investment performance."

Yet there was a weakness to the approach....

"Most of my gains in those early years, though, came from investments in mediocre companies that traded at bargain prices. Ben Graham had taught me that technique, and it worked.

But a major weakness in this approach gradually became apparent: Cigar-butt investing was scalable only to a point. With large sums, it would never work well.

In addition, though marginal businesses purchased at cheap prices may be attractive as short-term investments, they are the wrong foundation on which to build a large and enduring enterprise."

That's where Charlie Munger's influence comes into play...

"It took Charlie Munger to break my cigar-butt habits and set the course for building a business that could combine huge size with satisfactory profits."

Buffett goes on to explain it this way:

"What most of you do not know about Charlie is that architecture is among his passions. Though he began his career as a practicing lawyer...he designed the house that he lives in today – some 55 years later. (Like me, Charlie can't be budged if he is happy in his surroundings.) In recent years, Charlie has designed large dorm complexes at Stanford and the University of Michigan and today, at age 91, is working on another major project.

From my perspective, though, Charlie's most important architectural feat was the design of today's Berkshire. The blueprint he gave me was simple: Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices."

Munger thinks others would be wise to put at least part of what Berkshire has done into effect. Yet, in too many cases, they just don't.

So why don't more try to emulate Berkshire's approach? He thinks some of it comes down to how institutional forces impact behavior.

More from the same Daily Journal meeting:

There are vast institutional pressures on people to do it differently. Will it continue? I think Berkshire's going to continue way better than most people think. Way better. But there's so much power in what we already have. Part of the reason we have a decent record is that we pick things that are easy. Other people think they're so smart, they can take on things that are really difficult, and that proves to be dangerous.

You have to be very patient, you have to wait until something comes along, which, at the price you're paying, is easy. That’s contrary to human nature, just to sit there all day long doing nothing, waiting. It's easy for us, we have a lot of other things to do. But for an ordinary person, can you imagine just sitting for five years doing nothing? You don't feel active, you don't feel useful, so you do something stupid.

Munger then adds...

Three failing businesses together created Berkshire Hathaway. There are about the same number of shares outstanding now as they were then. I can't think of anything like it at this scale. You'd think people would be paying more attention to it than they do.

Part of the problem is it just appears to be too easy.

It looks so damned easy, they think there must be something wrong with it. The people there [at Berkshire, that is] don't work that hard. They have all these outside interests – Warren's playing bridge twelve hours a week (laughter). They just keep spinning and winning and it just looks too easy. So it's confusing. There must be something wrong with it. (laughter)

A sound investing approach need not be overly complex. Sometimes, very smart people seem willing to ignore a gem in plain sight and, instead, choose the path that's far more difficult. It's as if their abilities causes them to become bored by what's sensible and straightforward though maybe, at least seemingly, a little less challenging than they might like. Maybe they assume there must be more to it. Otherwise, why would such an approach work? Some of their behavior, as Munger points out, can be explained by pressures that are institutional in nature.

Now, that's not to suggest Berkshire's record is easy to replicate. It's clearly not. It does, however, at least imply that some participants would be well-served more carefully studying/thinking about what has led to such an astonishing result then figuring out how it might apply to their own situation and capabilities.
(And, where applicable, maybe spending less time attempting to speculate on near-term price action.)

Personally, if I couldn't find a plane and needed to get across the ocean I'd take a ship. Well, very intelligent and capable individuals at times choose the equivalent of attempting to get across on the back of a sailfish when a perfectly good ship is available.***

They take the tougher than necessary voyage that, in theory, could enhance returns but in the real world likely achieves a similar or even worse outcome.

A similar or worse reward at far greater risk.

Those who think -- and this is just one example among many -- Berkshire's record comes mostly down to the attractive deals Buffett negotiates have pretty much guaranteed they'll miss out on some important lessons.

Of course those deals to an extent matter, but they're just one part of the overall story in my view.

Similarly, each ingredient of the Berkshire investing recipe -- including (but not limited to) things like portfolio concentration, "float" utilization, margin of safety, wide economic moats/enduring advantages, able and trustworthy management, buying only what's understandable, being greedy when others are fearful, extreme patience, lots of cash/liquidity to allow for decisive action, etc. -- is important but, individually, only explains a small part of the exceptional long-term performance. In other words, in a vacuum just one or two of these, even if applied effectively, isn't likely to lead to an unusual result.

It's about how they all work together. What Munger has referred to as a "Lollapalooza Effect".

In fact, in a vacuum, some of these might lead to subpar or even disastrous results in the wrong hands. Those who choose to concentrate their portfolio without the requisite other capabilities comes to mind.
(Indexation at a low-cost ends up being, for many, often the vastly better way to go. It's not just John Bogle who argues for such an approach. Munger and Buffett have also both said as much.)

So the Berkshire approach isn't exactly rocket science but needs to be considered comprehensively. Those willing to do so might find some useful lessons. It can at first appear almost too straightforward, but the challenge of putting it into effect should not be underestimated.

Essentially, there are a number of important pieces that make up the Berkshire puzzle, and it's a mistake to assume one or two of those pieces could possibly provide a full enough picture to explain the exceptional long-term investment results.

Adam

Long position in BRKb established at much lower than recent prices; no position in DJCO.

* From some excellent notes that were taken at the meeting. These notes, presented in four parts, are well worth reading. Not a transcript.
** Charlie Munger also wrote a special letter.
*** Apparently, the sailfish can hit 68 mph for shorter periods of time. That is quicker than any other fish. So someone could, at least theoretically, get to their destination more quickly than on a ship. Obviously, that doesn't make it a brilliant alternative means of transport.
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