Wednesday, March 22, 2017

Buffett: Innovators, Imitators, & the Swarming Incompetents

From Warren Buffett's most recent Berkshire Hathaway (BRKa) shareholder letter:

"...the great majority of [investment] managers who attempt to over-perform will fail. The probability is also very high that the person soliciting your funds will not be the exception who does well. Bill Ruane – a truly wonderful human being and a man whom I identified 60 years ago as almost certain to deliver superior investment returns over the long haul – said it well: 'In investment management, the progression is from the innovators to the imitators to the swarming incompetents.'

Further complicating the search for the rare high-fee manager who is worth his or her pay is the fact that some investment professionals, just as some amateurs, will be lucky over short periods. If 1,000 managers make a market prediction at the beginning of a year, it's very likely that the calls of at least one will be correct for nine consecutive years. Of course, 1,000 monkeys would be just as likely to produce a seemingly all-wise prophet. But there would remain a difference: The lucky monkey would not find people standing in line to invest with him."

Buffett later adds:

"When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients."

What's an investor to do? According to Buffett, the vast majority of investors, large or small, would be better off owning index funds with reasonably low expenses.
(A view he's advocated previously including in the 2013 letter.)

Buffett, late last month on CNBC, further elaborated on his thinking on the high expenses investors often end up paying:

"The amount of money people wasted getting investment advice is just ridiculous in this country."

He then goes on to say:

" borders on obscene...I've known 10 or so people with modest amounts of money, I would bet a lot of money that they would do better than average. And I say that there are hundreds, maybe even thousands. But there's thousands, and thousands, and thousands and thousands of hedge fund managers charging two and twenty...And you don't get better because you charge a lot. I mean, that does not make you a better judge of securities or anything like that. And so the good salespeople, overwhelmingly, are the ones that attract the money, rather than the very few who are extraordinary at managing money."

Charlie Munger is, not surprisingly, included in that list of 10. Buffett says the people who he thought likely to do well in the investing business were not "the smartest guys necessarily in the world," but then added "although maybe Charlie is."

I find it very tough to argue with that.

Paying something like 1.5% per annum in incremental frictional costs -- or, incredibly, in some cases even more -- may not intuitively seem like a big deal but, on a compounded basis, the difference in long range outcomes is hardly insignificant.

Let's say a basket of investments increase in value -- before any fees -- at an annual rate of 5.0% for 25 years. Well, subtract those 1.5% in annual fees from the returns* over 25 years and you'll find that the gain takes a material haircut. In fact, after 25 years the investor ends up with only 60 cents on the dollar. So instead, for example, of having $ 100k in gains the investor instead keeps roughly $ 60k.**

It's the investor who puts capital at risk for many years yet a good chunk of the gains end up elsewhere.

What if the actual gains over 25 years end up being more modest?

Something like 1.5% annually before fees?

In that case, the gains to the investor would of course have to be zero since the 1.5% in fees exactly offset the returns. So, amazingly, the investment manager ends up with a positive, albeit reduced compared to the 5.0% scenario, result but the investor ends up breaking even. least for the manager.

Once again, remember who actually put the capital at risk here.

Now, what if returns before fees end up being less than 1.5% over 25 years? Well, it will produce a net loss for the investor. Those fees still have to be covered somehow and if gains aren't sufficient the costs must be subtracted from the funds initially invested. This creates a scenario where, once again, the manager gets a positive, though admittedly more muted, result while the investor necessarily incurs a loss.

So 1.5% per year in fees sounds kind of harmless until considered in dollar terms over a proper long-term investing horizon.

What if during -- or, especially, toward the end of -- the 25 year period there's a big decline in market prices? Well, if the money is not needed by the investor (and emotions don't take over) during such an event this need not be the end of the world. Prices may normalize if whatever precipitated the decline mostly comes to an end. Yet it is the investor who has to ride it out or otherwise take the hit. In other words, the manager keeps all those fees paid out in prior years no matter what happens. Add a couple of zeros or more to the numbers above and it's not difficult to see why, as Buffett said in the letter, usually it's "the managers who reap outsized profits, not the clients."

Some managers, of course, suggest they have the capability to produce even greater returns than the examples I've used above and, well, a small number might even achieve such a result (without taking crazy risks). Yet picking a manager beforehand who will actually end up being worth something like 1.5% per annum in fees is easier said than done. During bull markets, when returns seem like they'll indefinitely be high, the high fees being charged will also seem like not terribly important background noise. Unfortunately, it's likely that with a long enough investment time horizon -- multiple market environments that inevitably include the good, the bad, and the ugly -- the importance of those fees will, ultimately, more or less become foreground noise.

Big declines in capital markets from time to time are unavoidable.

When it will happen and to what degree is neither knowable nor controllable.

Keeping expenses low is.

Seems straightforward enough but far too many investors still find it difficult to keep what are mostly avoidable costs at reasonable levels.

The result? A quiet, meaningful, but largely unnecessary wealth transfer.

Dumb ideas emerge from time to time in investing; keeping a close eye on the frictional costs likely won't prove to be one of them.

If expenses are kept in check the bulk of the gains mostly benefit whoever has actually put capital at risk. If not, much of the value that should compound and accumulate over time will, instead, end up in someone else's pocket.

Naturally, as equity prices rise to premium levels -- compared to per share intrinsic business values -- future returns eventually become anywhere from diminished to entirely insufficient while, at the same time, the possibility of permanent capital loss increases.
(Especially when the investment horizon is too short.)

As always, the price paid is paramount. Otherwise terrific asset(s) can be turned into lousy investment(s) if the price paid is too high.

Inadequate margin of safety.

Reduced potential reward.

Greater risk of loss.

Despite the popular view reward and risk need not always be positively correlated.

It's impossible to ignore where equity valuations are now compared to not all that long ago.


Long position in BRKb established at much lower than recent market prices

Related posts:
Bogle & Buffett on Frictional Costs
Buffett on Active Investing
John Bogle: Arithmetic Quants vs Algorithmic Quants
Hedge Funds: Balancing Risk & Reward?
Index Funds vs Actively Managed Funds
John Bogle on Investor Returns
Buffett's Hedge Fund Bet
John Bogle's "Relentless Rules of Humble Arithmetic", Part II
Index Fund Investing Revisited
Howard Marks on Risk
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Risk and Reward Revisited
Newton's Fourth Law
Investor Overconfidence
Buffett on Risk and Reward
Margin of Safety & Mr. Market's Mood
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
When Genius Failed...Again

* Excluding tax considerations.
** If 4 times as much capital were invested but otherwise nothing changes in terms of performance, then the outcome over 25 years would of course be proportional (as far as returns and fees). At first this might seem fair enough. More money to manage...more fees, right? Yet, since we're still talking about the same 5% annualized return, those extra fees were generated simply because more assets were under management. Now, more assets no doubt will have some additional cost associated with them, but is 4 times more in fees really justified? Purchasing 4 times as many shares of a particular stock, for example, hardly increases the cost structure by four-fold. Does it really take 4 times the effort and skill to produce such a materially higher amount of fees? I think the question answers itself.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Wednesday, February 15, 2017

Berkshire Hathaway 4th Quarter 2016 13F-HR

The Berkshire Hathaway (BRKa3rd Quarter 13F-HR was released yesterday. Below is a summary of the changes that were made to the Berkshire equity portfolio during that quarter.
(For a convenient comparison, here's a post from last quarter that summarizes Berkshire's 3rd Quarter 13F-HR.)

There was both some buying and selling during the quarter. Here's a quick summary of the changes:*

Added to Existing Positions
Apple (AAPL): 42.1 mil. shares (276% incr.); stake = $ 6.6 bil.
Delta Air Lines (DAL): 53.7 mil. shares (847%); stake = $ 3.0 bil.
American Airlines (AAL): 23.8 mil. shares (109%); stake = $ 2.1 bil.
United Continental (UAL): 24.4 mil. shares (538%); stake = $ 2.1 bil.
Bank of New York (BK): 535 thous. shares (2%); stake = $ 1.0 bil.

I generally include above only those positions that were worth at least $ 1 billion at the end of the 4th quarter. In a portfolio this size -- more than $ 257 billion (equities, fixed income, cash, and other investments including Kraft Heinz: KHC at fair value) according to the latest available filing with roughly half made up of common stocks** -- a position that's less than $ 1 billion doesn't really move the needle much. No positions worth less than $ 1 billion were added during the quarter.

New Positions
Southwest Airlines (LUV): 43.2 mil. shares; stake = $ 2.2 bil.
Monsanto (MON): 8.04 mil. shares; stake = $ 846 mil.
Sirius XM Holdings (SIRI): 167 mil. shares; stake = $ 742 mil.

Warren Buffett previously mentioned that Berkshire had purchased shares of Southwest Airlines during the 4th quarter.

Berkshire's latest 13F-HR filing did not indicate any activity was kept confidential.

Occasionally, the SEC allows Berkshire to keep certain moves in the portfolio confidential. The permission is granted by the SEC when a case can be made that the disclosure may cause buyers to drive up the price before Berkshire makes its additional purchases.

Reduced Positions
No positions still value at more than $ 1 billion were sold during the quarter. Positions that were sold worth less than $ 1 billion include Wal-Mart (WMT) and Verizon (VZ),

Sold Positions
Deere & Company (DE)
Kinder Morgan (KMI)
Liberty Media/Formula One Group (FWONK) - Formerly LMCK
Liberty Media/Formula One Group (FWONA) - Formerly LMCA
Now, Inc. (DNOW)
Lee Enterprises (LEE)

Todd Combs and Ted Weschler are responsible for an increasingly large number of the moves in the Berkshire equity portfolio. These days, any changes involving smaller positions will generally be the work of the two portfolio managers.

Top Five Holdings
After the changes, Berkshire Hathaway's portfolio of equity securities remains mostly made up of financial, consumer and technology stocks (primarily IBM and Apple).

1. Kraft Heinz (KHC) = $ 28.4 bil.
2. Wells Fargo (WFC) = $ 26.4 bil.
3. Coca-Cola (KO) = $ 16.6 bil.
4. IBM (IBM) = $ 13.5 bil.
5. American Express (AXP) = $ 11.2 bil.

As is almost always the case it's a very concentrated portfolio. The top five often represent 60-70 percent and, at times, even more of the equity portfolio. In addition, Berkshire owns equity securities listed on exchanges outside the U.S., plus fixed maturity securities, cash and cash equivalents, and other investments.

The portfolio excludes all the operating businesses that Berkshire owns outright with ~ 361,000 employees (with 25 being at headquarters) according to the latest available letter. Numbers like these -- along with many other things of interest especially for Berkshire shareholders -- should be updated in the next annual report and letter.

Here are some examples of Berkshire's non-insurance businesses:

MidAmerican Energy, Burlington Northern Santa Fe, McLane Company, The Marmon Group, Shaw Industries, Benjamin Moore, Johns Manville, Acme Building, MiTek, Fruit of the Loom, Russell Athletic Apparel, NetJets, Nebraska Furniture Mart, See's Candies, Dairy Queen, The Pampered Chef, Business Wire, Iscar, Lubrizol, Berkshire Hathaway Automotive, Oriental Trading Company, Precision Castparts, and Duracell.
(Among others.)

In addition to the above businesses and investment portfolio, Berkshire's large insurance operation (BH Reinsurance, General Re, GEICO etc.) has historically been rather profitable while providing plenty of "float" for their investments.

See page 115 of the annual report for a more complete listing of Berkshire's businesses.


Long positions in BRKb, KO, WFC, and AXP established at much lower than recent market prices. Also, long positions in WMT and IBM established somewhat below recent market prices. (In each case compared to average cost basis.)

* All values shown are based upon the last trading day of the 4th quarter.
** Berkshire Hathaway's holdings of ADRs are included in the 13F. What is not included are shares listed on exchanges outside the United States. The status of those shares, if a large enough position, are updated in the annual letter. So the only way any of the stocks listed on exchanges outside the U.S. will show up in the 13F is if Berkshire buys the ADR. Investments in things like preferred shares (and valuable warrants, where applicable, as explained in the recent letters) are also not included in the 13F.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Tuesday, January 10, 2017

Quotes of 2016

Here's a collection of quotes said or written at some point during 2015.

Buffett on Stock-Based Compensation
" has become common for managers to tell their owners to ignore certain expense items that are all too real. 'Stock-based compensation' is the most egregious example. The very name says it all: 'compensation.' If compensation isn't an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?

Wall Street analysts often play their part in this charade, too, parroting the phony, compensation-ignoring 'earnings' figures fed them by managements. Maybe the offending analysts don’t know any better. Or maybe they fear losing 'access' to management. Or maybe they are cynical, telling themselves that since everyone else is playing the game, why shouldn’t they go along with it. Whatever their reasoning, these analysts are guilty of propagating misleading numbers that can deceive investors." - Warren Buffett

Bezos: The "Inseparable Twins" of Failure and Invention
"...corporate cultures...are enduring, stable, hard to change. They can be a source of advantage or disadvantage. You can write down your corporate culture, but when you do so, you're discovering it, uncovering it – not creating it. It is created slowly over time by the people and by events – by the stories of past success and failure that become a deep part of the company lore. If it's a distinctive culture, it will fit certain people like a custom-made glove. The reason cultures are so stable in time is because people self-select. Someone energized by competitive zeal may select and be happy in one culture, while someone who loves to pioneer and invent may choose another. The world, thankfully, is full of many high-performing, highly distinctive corporate cultures. We never claim that our approach is the right one – just that it's ours – and over the last two decades, we’ve collected a large group of like-minded people. Folks who find our approach energizing and meaningful.

One area where I think we are especially distinctive is failure. I believe we are the best place in the world to fail (we have plenty of practice!), and failure and invention are inseparable twins. To invent you have to experiment, and if you know in advance that it’s going to work, it’s not an experiment. Most large organizations embrace the idea of invention, but are not willing to suffer the string of failed experiments necessary to get there." - Jeff Bezos

Buffett: The "Double-Barrel Effect"
"The ideal business is one that takes no capital but yet grows...if you have a business that grows, and gives you a lot of money every year, [capital] isn't required in its growth, you get a double-barrel effect: from the earnings growth that occurs internally without the use of capital, and then you get the capital it produces to go and buy other businesses.

And See's Candy was a good example of that." - Warren Buffett

Berkshire 2016 Meeting: Charlie Munger Highlights - Part I

"...looking back, I don't regret that I didn't make more money or become better known, or any of those things. I do regret that I didn't wise up as fast as I could have — but there's a blessing in that, too. Now that I'm 92, I still have a lot of ignorance left to work on." - Charlie Munger

"...every person has to have about eight or ten glasses of water every day to stay alive...and it improves life to add a little extra flavor to your water -- a little stimulation, and a few calories if you want to eat that way. There are huge benefits to humanity in that and it's worth having some disadvantages. We ought to almost have a law...where these people shouldn't be allowed to cite the defect without also citing the advantage. It's immature and stupid."

"Well, there could hardly be anything more important [than microeconomics]....Business and microeconomics are sort of the same term. Microeconomics is what we do and macroeconomics is what we put up with." - Charlie Munger

Berkshire 2016 Meeting: Charlie Munger Highlights - Part II
"We try to avoid the worst anchoring effect, which is always your previous conclusion. We really try and destroy our previous ideas." - Charlie Munger

"What you've got to do is be aversive to the standard stupidities. If you just keep those out, you don't have to be smart." - Charlie Munger

"...sometimes when you reduce volume it is very intelligent because you're losing money on the volume you're discarding. It's quite common for a business not only to have more employees than it needs, but it sometimes has two or three customers that could be better off without. So it's hard to judge from outside whether things are good or bad just because volume is going up or down a little." - Charlie Munger

"I don't think anybody really knows much about negative interest rates...None of the great economists who studied this stuff and taught it to our children understand it either...our advantage is that we know we don't understand it." - Charlie Munger

Buffett on Active Investing
"Supposedly sophisticated people, generally richer people, hire consultants, and no consultant in the world is going to tell you 'just buy an S&P index fund and sit for the next 50 years.' You don't get to be a consultant that way. And you certainly don't get an annual fee that way. So the consultant has every motivation in the world to tell you, 'this year I think we should concentrate more on international stocks,' or 'this manager is particularly good on the short side,' and so they come in and they talk for hours, and you pay them a large fee, and they always suggest something other than just sitting on your rear end and participating in the American business without cost. And then those consultants, after they get their fees, they in turn recommend to you other people who charge fees, which... cumulatively eat up capital like crazy." - Warren Buffett

Bogle & Buffett on Frictional Costs
"We have two [investment] managers at Berkshire. They each manage $9 billion for us. They both ran hedge funds before. If they had a 2/20 arrangement with Berkshire, which is not uncommon in the hedge fund world, they would be getting $180 million annually each merely for breathing. It's a compensation scheme that is unbelievable to me..." - Warren Buffett

Happy New Year,


Quotes of 2015 
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
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