Should Buffett Buy Uber?

A recent Fortune article made the case for something that at first glance seems rather unlikely. In it, Dan Primack argues that Warren Buffett should consider buying Uber. With this in mind and for context, let's look at some things Buffett has written over the years. Back in 2007, Berkshire Hathaway's (BRKa) four largest equity investments were Coca-Cola (KO) Wells Fargo (WFC), American Express (AXP), P&G (PG).

Here's what he had to say about those investments:

"...note that American Express and Wells Fargo were both organized by Henry Wells and William Fargo, Amex in 1850 and Wells in 1852. P&G and Coke began business in 1837 and 1886 respectively. Start-ups are not our game." - From the 2007 Berkshire letter

Three of those stocks remain top four holdings. More recently (over the past five years or so) some of Buffett's bigger purchases -- everything from partial ownership via equities to outright acquisitions -- have included things like Burlington Northern Santa Fe, Lubrizol, IBM (IBM), Heinz, Exxon Mobil (XOM), and Duracell. The youngest of these businesses is 86 years old. So, to say the very least, Buffett generally likes businesses with a very long track record that are less likely to experience major change* -- especially the kind of change that fundamentally alters the core business economics -- going forward.

"In studying the investments we have made in both subsidiary companies and common stocks, you will see that we favor businesses and industries unlikely to experience major change. The reason for that is simple: Making either type of purchase, we are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek." - From the 1996 Berkshire letter

So Uber would be a rather significant break, I think it's fair to say, from Berkshire's traditional approach.  Startups -- even very successful ones -- that compete in a rapidly changing environment isn't usually a part of the Berkshire playbook. Yet you never know. If the price was right, maybe something that now seems rather improbable could suddenly make a whole lot of sense.

The fact is that there have been many great businesses launched -- and Uber just might prove to be one of them though, at this point, I have no idea -- during the period that Buffett has been managing Berkshire (roughly five decades).

Berkshire's success over that time -- a 693,518% total return through the end of last year -- has essentially come from none of them.**

Many more great businesses will no doubt be created in the coming decades.

It seems likely they also won't be contributing much to Berkshire's intrinsic value going forward.

If nothing else, Berkshire's approach shows that attractive investment results do not necessarily depend on some unusual acuity for finding the next big thing. Exciting growth prospects and dynamic change might, in fact, offer the possibility for big investment gains. The problem is they also sometimes offer the chance to lose a whole lot of money. Big wins and big losses usually reside in the same neighborhood. They can be tough to reliably tell apart beforehand without making large mistakes.

This is not only due to unpredictable future prospects and a wide range of possible outcomes; this is also because the price one usually has to pay upfront for the most promising businesses is rather high.

Insufficient margin of safety.

Of course, some might be able to reliably pick the big winners, but it's easy to underestimate how difficult this is to do without also incurring big losses.

That may offer a more exciting ride but it's the net result, in the context of risk, that matters.

Owning businesses that can maintain attractive economics for decades, bought at a reasonable price or, better yet, at a meaningful discount to a conservative estimate of value, isn't a bad way to balance risk and reward. Exciting growth prospects not required.

Almost any business -- even a very good one -- will eventually experience real difficulties and unexpected challenges. Buffett's approach is, in part, an attempt to reduce the likelihood that investment results will be ruined by what are almost inevitable future business challenges.

"It's vital, however, that we recognize the perimeter of our 'circle of competence' and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses." - From the 2013 Berkshire Hathaway letter

So, even with such an approach, mistakes will still get made.

Just because a particular business has succeeded for a very long time guarantees absolutely nothing.

Adam

Long positions in all common stocks mentioned excluding XOM

* This is not meant to be an all-inclusive list of Berkshire's more recent investment activity but, instead, just some good examples of the larger moves that have been made. Burlington Northern's historical lineage dates back to the late 1840s. Heinz was founded in 1869. Exxon was formed in 1870. IBM was founded in 1911. Duracell began in 1916. Lubrizol was founded in 1928. The names may have changed over time but all of these go back quite a ways. Naturally, all of these businesses have dealt with change over time but the question is how likely those changes will damage business economics. IBM would seem to fit the least well when it comes down to whether its business is likely to experience major change going forward. The Heinz investment is made up of common stock, warrants, and preferred shares. Berkshire also made a large investment in Bank of America (BAC) preferred stock and warrants. It won't be clear for some time how much BofA common stock Berkshire will end up owning though at this point it appears that it will be substantial. Once again, the bank isn't exactly a startup.
** This total return over five decades or so means that $ 10,000 invested in Berkshire would have grown to just under $ 70 million.
---
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.

Aesop's Investment Axiom Revisited

In this prior post, I included the following excerpt from the 2000 Berkshire Hathaway (BRKa) shareholder letter:

"...Aesop and his enduring, though somewhat incomplete, investment insight was 'a bird in the hand is worth two in the bush.' To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? "

Aesop's Investment Axiom

Warren Buffett adds that, if the investor can answer these questions, then both the value and the number of "birds" that should be offered can be understood.

"And, of course, don't literally think birds. Think dollars."

Buffett also writes that the difference between investing and speculating may never be "bright and clear" but the differences do matter. Here's one simple attempt, if limited imperfect way, to make a distinction.

The speculator would be generally troubled if the price of an asset dropped substantially -- even if temporarily -- after purchase. We're talking about necessarily rather short time horizons. So the emphasis is not only on price action going in the right direction, but as soon as possible. When dealing with such short time frames, the reason for the drop ends up mattering not much at all.

Whether the drop is caused by emotions, perceptions, technical factors, the market environment as a whole, or real company specific problems just isn't relevant. With speculation, it's the price action that rules.

The investor should be generally troubled, instead, only if the intrinsic value of something went down substantially after purchase. The emphasis is on price versus value; it's on the stream of cash flows that an asset can produce over the long haul; it's on Aesop's investment axiom. With investment, it's the value that rules.

A drop in what something is intrinsically worth (or if value was misjudged in the first place) is when there's a real chance of permanent capital loss. Otherwise, for the investor, a price dropping against well-judged value can be a very good thing.

Buffett explained it the following way back in 2009:

"When I do invest, I don't care if the stock price goes from $10 to $2 but I do care about if the value went from $10 to $2."

If the investor pays a discount to what that future stream of income is worth in present terms, why should a further drop in price be a problem? Of course an investor wants market prices to reflect the actual business economics in the long run. Yet, the participant with a true emphasis on investment should know that a near-term (or even longer) drop in price is a good thing if it represents an increasingly large discount to estimated value.

Some might correctly make the point that the speculator (with a long position) also likes to see value going up. While this is true, the speculator is not concerned with whether there was an actual change in value, or whether emotions, perceptions, or something else has temporarily moved the market price.

The price needs to increase, for whatever reason, just long enough to sell; enduring value is of little concern.

Now, it's not like non-fundamental forces don't potentially help the investor as well. If, for example, the shares happen to temporarily sell at a bigger discount because of psychological factors that can serve the long-term oriented owner very well. Still, favorable investment outcomes mostly come down to what the business itself produces long-term.

It mostly comes down to whether enduring value is created over time.

Prices from time to time in capital markets will go to extremes.*

From an interview with Buffett:

"Basically, it's subjective, but in investment attitude you look at the asset itself to produce the return."

He adds:

"On the other hand if I buy a stock and I hope it goes up next week, to me that's pure speculation."

For the investor it's about the long run core economics of the business.

For the speculator it's the price.

It may not be black and white -- and there's surely plenty of overlap -- but the differences do matter.

Ben Graham long ago expressed concerns that the two distinct activities were becoming blurred.

Also, John Maynard Keynes once wrote:

"If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life, it is by no means always the case that speculation predominates over enterprise. As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase."

Keynes understood that investing was mostly about what an enterprise could produce over time.
(Apparently, for Keynes, the word enterprise and investment were equivalent.)

John Bogle certainly seems to think that speculation and investment has unfortunately become nearly equivalent in the minds of too many.

Keep in mind I'm not suggesting there's something inherently wrong with speculation. Both investment and speculation can be useful in the right proportion. I'd argue the whole system has evolved to overemphasize the latter. Capital markets might just end up functioning in a way that better serves us if the distinction was more broadly appreciated. Considering where we are today, some sensible changes that encourage greater engagement in true investment activities by more participants seems in order.

These days, instead, stock "rental" dwarfs ownership.**

Meaningful improvements to the situation appear very unlikely unless it also occurs at a cultural level. How many today associate the stock market with the convenient ownership of businesses for the long run? I think it's fair to say that many think of it, first and foremost, as a place to speculate on stocks. Change how that question is generally answered and maybe, albeit no doubt slowly, behavioral norms might just change. The emphasis may become more about long-term effects and outcomes; it may become more about wise capital formation and allocation.

Nothing about the current situation is inevitable. That doesn't mean improvements will come easily. Even some modest enhancements in this regard would be a healthy development.

Also, for those who see stocks for what they are -- convenient partial business ownership -- and can resist the temptation to trade frenetically, the fact is it has never been more straightforward and low cost to invest for the long haul.

It's not a good thing that these two distinct activities are now so often viewed as being nearly one and the same. That's not to say there isn't a place for speculation. Trading with an emphasis on the short-term is a necessary and useful element in the capital markets. At least, it is up a point. Just because a certain amount of something is useful doesn't logically mean more of it is even more wonderful. With systems, even relatively simple ones, the right proportion matters.

I mean,take something like a petrol engine. It works just fine with the right amount of air and fuel. Well, at least it does if the ratio remains within a narrow range. Yet, step outside that range and it just doesn't work. So the right amount of fuel is a good thing but, eventually, too much of it begins hurting engine performance.

This is just one less than perfect, but possibly useful, way to think about the implications of excessive speculation.

More from the 2000 Berkshire letter:

"...there are many times when the most brilliant of investors can't muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed. This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination. In cases of this sort, any capital commitment must be labeled speculative.

Now, speculation -- in which the focus is not on what an asset will produce but rather on what the next fellow will pay for it -- is neither illegal, immoral nor un-American. But it is not a game in which Charlie and I wish to play. We bring nothing to the party, so why should we expect to take anything home?

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money."

There is nothing inherently wrong with speculation but each participant should know where their own true emphasis lies.

Keep in mind that both speculation and investment may utilize fundamental factors to guide their decisions.

So the difference does not necessarily come down to whether the fundamentals influence decision-making. Occasionally, I'll hear or read that someone is a "fundamental investor". Yet their typical holding period will be very short.

Well, that's still mostly speculation in my book. The fact that fundamentals are taken into account does not turn the activity into investment.

There's nothing inherently wrong with speculation but it shouldn't be confused with investment; they're, in fact, two rather distinct activities.

The real problem with speculation is that, for too many, it creates high levels of activity and frictional costs instead of high returns. Lots of effort; modest rewards or losses.

There's nothing wrong with speculation until the vast proportion of market participants are engaged in it.

There's nothing wrong with speculation unless the scale becomes so large that it absorbs lots of capable people who could, instead, be engaged in something more productive and useful.

Come to think of it, there's plenty wrong with amount of speculation these days.

Adam

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

Related posts:
Munger: "Cognitive Failure" In Economics
Ignore The Noise: John Bogle on Market Fluctuations
Aesop's Investment Axiom
Margin of Safety & Mr. Market's Mood
On Speculation and Investment
John Bogle: The Clash of the Cultures
Buffett on Gambling and Speculation
Buffett on Speculation and Investment - Part II
Buffett on Speculation and Investment - Part I
Buffett: "Two Types of Assets"
Munger: "Separate Derivatives from the Basic Bridges of Civilization"
Bogle: History and the Classics
"Stock Renters"
Buffett on Aesop's Formula for Value
Michael Porter on Business and Investing

* This inherent moodiness should either be ignored or turned into an advantage. A temporary drop in price even further below well-judged value provides a chance to buy more shares at a discount. The other extreme might offer the opportunity to sell. The tough part is avoid being tempted toward excessive amounts of activity. Otherwise, investment will quickly morph into speculation even with the best intentions. Excessive activity can lead to lots of unnecessary mistakes and frictional costs. Also, equities will always become mispriced, but that doesn't make attempts to reduce the damage these huge distortions can do not worthwhile. The current system seems, at times, a capital misallocation machine. The compounded effect of such things is almost certainly harmful.
** How many drive a rental car with the idea they want to make sure it remains a useful asset for as long as possible? Well, when speculation and short-term oriented traders -- the "renters" -- dominate, maybe some valuable business assets end up being treated much like that rental car. When the intent is to own something for minutes, days, weeks, months, or even a few years, the long-term implications of decisions being made today can take a back seat. Well, even the best businesses face unique challenges and opportunities. More true "owners" would be welcome. The average public company may then just end up with improved governance and executive leadership. 
---
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.

Buffett & Munger on Compensation - Part II

A follow up to this post. In this CNBC interview, Warren Buffett helps explain why less than optimal compensation systems come to exist in the first place:

"...once a board has delegated to a committee and they've spent hours working on something, and then they report it and there's 20 other items on the agenda and the Chairman calls on the comp committee to give his report and gives it in about 30 seconds, it never gets voted against. And it would be regarded as sort of usurping the power of the committee to all of a sudden say I've got a better idea. I haven't talked to the compensation consultants, I haven't looked at the figures, but I still have a better idea. It doesn't happen."

Becky Quick -- the CNBC interviewer -- brought up the idea that corporate boards might become rather clubby at times. Buffett responded by saying he finds it "always interesting...to read academic discussions of boards." Some have a tendency to overestimate the likelihood that corporate board actions will be primarily about "business maximization" and underestimate the social component.

"...boards are in part business organizations and in part social organizations. People walk into those with their behavior formed by dozens of — usually your people have achieved some standing, perhaps, in the community. So they've learned how to get along with other people. And they don't suddenly change their stripes when they come into a board meeting. So there's a great tendency to behave in a socially acceptable way and not necessarily in a business maximization way. The motives are good; the behavior is formed by decades earlier."

That comment about boards being social organizations -- and the implications for owners -- deserves some attention. In the real world, corporate board behavior isn't, as some might like to imagine, necessarily all about what's best for the business and owners. During the same interview, Andrew Ross Sorkin later asked:

"I hear you saying this is what happens. My question is should it happen this way?"

Buffett's response:

"Well, no, obviously you know everybody would speak freely and all of that sort of thing, and dialogue would be encouraged and the chairman would love to hear reasons why his ideas were no good, but it isn't quite that way."

Buffett later goes on to explains another important dynamic at work:

"There are a number of directors at any company that are making two or three hundred thousand dollars a year, and that money is important to them. And what they really hope is they get invited to go on other boards.

Now if a CEO comes to another CEO and says I hear you've got so-and-so on the board, we need another woman or whatever it may be, oh, she will behave.

If they say she raises hell at every meeting, she's not going to be on the next board. On the other hand, if they say she's constructive, her compensation committee recommendations have been spot on, et cetera, she's got another $300,000 a year job. That's the real world."

These are, at least in some ways, remarkably blunt comments that reveals just how social -- and not surprisingly a bit self-serving -- things end up being on at least some boards. The idea that "business maximization" is what boards are about is an invented version of how humans -- even very capable ones -- are likely to behave in groups. The error of expecting otherwise seems similar to the error of assuming that market participants will mostly act in a cold and rational manner.

There are, of course, some very good boards. That doesn't mean many boards are not susceptible to some of these adverse dynamics.

It's worth noting that, unlike many other companies, non-executive board members at Berkshire Hathaway (BRKa) do not get paid.

Here's Charlie Munger's take:

"You start paying directors of corporations two or three hundred thousand dollars a year, it creates a daisy chain of reciprocity where they keep raising the CEO and he keeps recommending more pay for the directors..."

He also said the following when asked about the unconventional view that lots of disclosure regarding executive compensation is not necessarily the best thing for shareholders:

"I think envy is one of the major problems of the human condition... And so I think this race to have high compensation because other people do, has been fomented by all this publicity about higher earnings. I think it's quite counterproductive for the nation. There's a natural reaction to all this disclosure because everybody wants to match the highest."

Buffett followed with this:

"It's very natural to think if you're a director of the ABC Corp. and the CEO of the XYZ Corp is getting more, well, our guy is at least as good as theirs. And it goes on and on and on.

So publication of the top salaries has cost the American shareholder money. Maybe disclosure is the great disinfectant, all of that, sunshine is the great disinfectant. Sunshine has cost American shareholders money when it comes to paying their managers."

Munger then quipped that it's "a peculiarity of ours, but we're right".

Basically, publishing the information creates envy that leads to higher pay packages. They think people will generally expect to earn more when they see what others are earning.

In the 2006 letter, Buffett offers some thoughts on Berkshire's board (page 18) and compensation practices (starting at the bottom of page 19).

Also, for some additional thoughts on compensation -- including the misalignment of interests that can occur with stock options -- check out the Compensation section of the 1994 letter.

Adam

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

Related posts:
Buffett & Munger on Compensation - Part I
The Illusion of Consensus
---
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.
(1, 6)

Buffett: How to Minimize Investment Returns

At the beginning of the "How to Minimize Investment Returns" section found in the 2005 Berkshire Hathaway (BRKa) shareholder letter, Warren Buffett mentions that the Dow increased from 65.73 to 11,497.12 during the 20th century.*

He then says:

"This huge rise came about for a simple reason: Over the century American businesses did extraordinarily well and investors rode the wave of their prosperity. Businesses continue to do well. But now shareholders, through a series of self-inflicted wounds, are in a major way cutting the returns they will realize from their investments."

The reason is straightforward enough as Buffett goes on to point out. He says the "fundamental truth" is that owners, in aggregate, can only earn what the businesses, in aggregate, earn over time. 

Naturally, individual participants attempt to gain advantage over other participants. 

Yet, it's not difficult to show how unwise this behavior generally ends up being.
(More on this below.)

I'd emphasize Buffett's point above that "businesses continue to do well."

Why?

Well, as long as a fair price is paid in the first place, how the businesses perform will be the long-term driver of future returns.

Buffett adds this later in the letter:

"For owners as a whole, there is simply no magic – no shower of money from outer space – that will enable them to extract wealth from their companies beyond that created by the companies themselves.

Indeed, owners must earn less than their businesses earn because of 'frictional' costs. And that's my point: These costs are now being incurred in amounts that will cause shareholders to earn far less than they historically have.

To understand how this toll has ballooned, imagine for a moment that all American corporations are, and always will be, owned by a single family. We'll call them the Gotrocks."

In 2005, American corporations were earning roughly $ 700 billion each year and, as outright owners, this fictional family will spend obviously some of it. Yet that remaining large unspent portion is saved and compounds for these continuing long-term owners. More from Buffett:

"In the Gotrocks household everyone grows wealthier at the same pace, and all is harmonious.

But let's now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others. The Helpers – for a fee, of course – obligingly agree to handle these transactions. The Gotrocks still own all of corporate America; the trades just rearrange who owns what. So the family's annual gain in wealth diminishes, equaling the earnings of American business minus commissions paid. The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend and, in a wide variety of ways, they urge it on.

After a while, most of the family members realize that they are not doing so well at this new 'beat-my-brother' game. Enter another set of Helpers. These newcomers explain to each member of the Gotrocks clan that by himself he'll never outsmart the rest of the family. The suggested cure: 'Hire a manager – yes, us – and get the job done professionally.' These manager-Helpers continue to use the broker-Helpers to execute trades; the managers may even increase their activity so as to permit the brokers to prosper still more. Overall, a bigger slice of the pie now goes to the two classes of Helpers.

The family's disappointment grows. Each of its members is now employing professionals. Yet overall, the group's finances have taken a turn for the worse. The solution? More help, of course.

It arrives in the form of financial planners and institutional consultants, who weigh in to advise the Gotrocks on selecting manager-Helpers. The befuddled family welcomes this assistance. By now its members know they can pick neither the right stocks nor the right stock-pickers. Why, one might ask, should they expect success in picking the right consultant? But this question does not occur to the Gotrocks, and the consultant-Helpers certainly don’t suggest it to them.

The Gotrocks, now supporting three classes of expensive Helpers, find that their results get worse, and they sink into despair. But just as hope seems lost, a fourth group – we'll call them the hyper-Helpers – appears. These friendly folk explain to the Gotrocks that their unsatisfactory results are occurring because the existing Helpers – brokers, managers, consultants – are not sufficiently motivated and are simply going through the motions. 'What,' the new Helpers ask, 'can you expect from such a bunch of zombies?'

The new arrivals offer a breathtakingly simple solution: Pay more money. Brimming with self-confidence, the hyper-Helpers assert that huge contingent payments – in addition to stiff fixed fees – are what each family member must fork over in order to really outmaneuver his relatives.

The more observant members of the family see that some of the hyper-Helpers are really just manager-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND or PRIVATE EQUITY. The new Helpers, however, assure the Gotrocks that this change of clothing is all-important, bestowing on its wearers magical powers similar to those acquired by mild-mannered Clark Kent when he changed into his Superman costume. Calmed by this explanation, the family decides to pay up.

And that's where we are today: A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers. Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked).

A sufficient number of arrangements like this – heads, the Helper takes much of the winnings; tails, the Gotrocks lose and pay dearly for the privilege of doing so – may make it more accurate to call the family the Hadrocks. Today, in fact, the family's frictional costs of all sorts may well amount to 20% of the earnings of American business. In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one."

This 80% number might seem extreme. It's not. The reality that roughly 80% of returns is now going to "helpers" has been highlighted by John Bogle as well:

"Think about that. That means the financial system put up zero percent of the capital and took zero percent of the risk and got almost 80 percent of the return, and you, the investor in this long time period, an investment lifetime, put up 100 percent of the capital, took 100 percent of the risk, and got only a little bit over 20 percent of the return. That is a financial system that is failing investors because of those costs of financial advice and brokerage, some hidden, some out in plain sight, that investors face today. So the system has to be fixed."

Buffett closes the "How to Minimize Investment Returns" section of the letter with the quote about Sir Isaac Newton that's located in the upper right hand corner of this blog.

For lots of reasons, I've liked the story of Isaac Newton's speculative folly for quite a long time. It not only highlights that being very smart and investment success need not have much to do with each other; it also highlights, despite massive progress in other ways, the persistence of human nature and how unlikely it is to change. Similar mistakes are made under what seems to be not sufficiently different circumstances. The lessons are there for the taking but not applied. Buffett's quote about Newton provides another dimension: The folly of allowing market hyperactivity and frictional costs to enter the equation. It emphasizes how poorly lots of trading activity is going to work out for investors as a whole. Of course, that leads many to conclude they'll be on the right side of this gross returns minus frictional costs game. What Buffett calls the "'beat-my-brother' game." Well, for most market participants, the odds aren't good that this approach will fatten their portfolio. It would seem that Buffett's parable and all the other available evidence would make this pretty obvious but, well, history suggests it won't change behavior.**

Some will rightly conclude that there's no point to buying individual stocks. For many that's the right conclusion. The good news is there are many convenient, low frictional cost ways available to approach long-term investment this way. Still, for those inclined and able to judge the prospects of a business well, the same essential lesson applies: It makes little sense to allow all the frictional costs to creep into the process.
(Not to mention the chance for additional misjudgments. When an action is taken, how the move might improve results isn't the only consideration. In fact, it's the opposite outcome that just might deserve greater consideration.)

Buffett points out that the annual growth rate required to produce an increase from 66 to 11,497 over 100 years was 5.3%.

Compounding is a powerful force.

Keep in mind that, in addition to that not exactly modest increase, long-term investors would have received a not at all small quantity of aggregate dividends (which were, earlier in that century, a much larger part of total returns) over that time frame.

Investment results via marketable stocks -- in contrast to speculative results -- come primarily from the increase to per share intrinsic business value (driven by what the business earns, in aggregate, over time). Those that achieve (or claim to achieve) above average results via cleverly timed trades make for great stories and headlines. Some individuals will actually even succeed at this kind of approach but results, in total, will otherwise inevitably be gross returns minus frictional costs. It's one of "the relentless rules of humble arithmetic."

So sure there will be exceptions, but is it wise to engage in a strategy that's based upon being the exception?

At any point in time some market participant will be able to promote the brilliant trade they made. It might even get its fair share of coverage. The incentive to boast is surely there. I'm guessing the not so brilliant trades will get promoted just a bit less.

Best to trust only carefully audited results over very long time frames.

Otherwise, skepticism is very much warranted.

Investing well means not being impressed by -- and not being susceptible to -- the compelling "story". That's not only true when attempting to judge the actual capabilities and results of other market participants. That's true when judging the risk-adjusted prospects of a particular investment alternative.

Investing is about how price compares to value.

It's about how well value is truly understood (or can be understood).

It's not about how compelling the "story" sounds.

In any case, hyperactivity among market participants, combined with the willful payment of excessive fees, is a recipe for making the "helpers" rich and paying lots of taxes.

Those putting up the capital take essentially all the risk (well, at least beyond "career risk") and end up compensated insufficiently or worse.

Adam

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

* Pages 18-19 of the letter.
** If attractive long run results at the lowest possible risk is the objective, being realistic about not only one's own capabilities, but also what approach has a high likelihood of working over time, is a good chunk of the battle. Unfortunately, overconfidence in abilities and overestimating future prospects gets in the way and, naturally, isn't likely to end up being particularly lucrative. Of course, efficient market hypothesis doesn't allow for such an outcome -- less risk, more reward -- but that's another subject altogether.
---
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.

Charlie Munger: Gresham's Law (In Its New Form)

Gresham's Law - A monetary principle stating that "bad money drives out good." - Investopedia

If someone wants to better understand how Charlie Munger and Warren Buffett think about the insurance business, this turns out to be a useful principle to understand.

Gresham's Law in its original form, according to Charlie Munger, is a "non-starter" for today's world. It just isn't terribly relevant these days.

Yet it is extremely relevant in the newer form that Munger describes below:

"Nobody cares what the melt-down value of the quarter is in relationship to the dime, so Gresham's Law is a non-starter in the modern world. Bad money drives out good. But the new form of Gresham's Law is ungodly important. The new form of Gresham's Law is brought into play - in economic thought, anyway - in the savings and loans crisis, when it was perfectly obvious that bad lending drives out good. Think of how powerful that model is. Think of the disaster that it creates for everybody. You sit there in your little institution. All of the builders [are not good credits anymore], and you are in the business of lending money to builders. Unless you do the same idiotic thing [as] Joe Blow is doing down the street. Pete Johnson up the street wants to do something a little dumber and the thing just goes to a mighty tide. You've got to shrink the business that you love and maybe lay off the employees who have trusted you their careers and so forth or [make] a lot of dumb loans. At Berkshire Hathaway we try and let the place shrink. We never fire anybody, we tell them to go out and play golf. We sure as hell don't want to make any dumb loans. But that is very hard to do if you sit in a leadership position in society with people you helped recruit, you meet their wives and children and so forth. The bad loans drive out the good. 

It isn't just bad loans. Bad morals drive out the good." - Charlie Munger at Harvard-Westlake School in 2010

This doesn't just apply to making loans.

It just as comfortably applies to the insurance business.

To understand Berkshire's willingness to shrink a business with Gresham's Law (in its new form) in mind, consider the example of National Indemnity (NICO) -- a property and casualty insurance company.

Here's how Buffett explained it in the 2004 Berkshire Hathaway (BRKa) shareholder letter:

"Insurers have generally earned poor returns for a simple reason: They sell a commodity-like product."

NICO is fundamentally a commodity business.

"Customers by the millions say 'I need some Gillette blades' or 'I'll have a Coke' but we wait in vain for 'I'd like a National Indemnity policy, please.' Consequently, price competition in insurance is usually fierce. Think airline seats.

So, you may ask, how do Berkshire's insurance operations overcome the dismal economics of the industry and achieve some measure of enduring competitive advantage?"

How does this relate to Munger's version of Gresham's Law? Well, for starters Buffett asserts:

"Nevertheless, for almost all of the past 38 years, NICO has been a star performer. Indeed, had we not made this acquisition, Berkshire would be lucky to be worth half of what it is today."

In the letter, there is a table that shows NICO allowed written premiums to drop from $ 366 million in 1986 to $ 54 million in 1999.

An 85 percent decline.

So Munger wasn't kidding when he says they are willing to let the business shrink to combat Gresham's Law in its new form.

How did this challenging business contribute so much value to Berkshire when the industry overall, excluding Berkshire, mostly operates at an underwriting loss?

How does so much value get created when a business is allowed to shrink that much for such a long period of time?

Again, as Buffett pointed out, this has contributed roughly half of Berkshire's total.

I'd say this all qualifies as just a bit counterintuitive.

It comes from a kind of discipline that many find difficult to emulate considering real world pressures and other behavioral tendencies. More from the letter:

"Can you imagine any public company embracing a business model that would lead to the decline in revenue that we experienced from 1986 through 1999?  That colossal slide, it should be emphasized, did not occur because business was unobtainable. Many billions of premium dollars were readily available to NICO had we only been willing to cut prices. But we instead consistently priced to make a profit, not to match our most optimistic competitor. We never left customers – but they left us.

Most American businesses harbor an 'institutional imperative' that rejects extended decreases in volume. What CEO wants to report to his shareholders that not only did business contract last year but that it will continue to drop?  In insurance, the urge to keep writing business is also intensified because the consequences of foolishly-priced policies may not become apparent for some time. If an insurer is optimistic in its reserving, reported earnings will be overstated, and years may pass before true loss costs are revealed (a form of self-deception that nearly destroyed GEICO in the early 1970s)."

As I said in this previous post:

Shareholders of many commodity-like businesses that are run with the Berkshire mindset have a much better chance of being served well in the long run. For example, the next time a banker is promising consistently high earnings growth it would be wise to remember the above because it generally applies.

That is not a bank I'd want to own.

For some commodity-like businesses, at times the smartest thing to do is intelligently shrink, even if less dramatically than the NICO example above, until the competitive landscape produces a pricing environment supportive of high returns.

Finding a business leadership team who not only understands but acts in accordance with this isn't easy.

Self-interest, and other powerful psychological factors (subconscious and conscious) can lead to cognitive errors that adversely affect even the very brightest (this includes those who might be quite admirable in other ways). There just are aspects of human nature that can lead to less than optimal outcomes.

It has little to do with how smart those involved happen to be.

I happen to think this aspect of Berkshire's overall success frequently goes underappreciated. I also happen to think, if internalized, this way of thinking can be both useful to long-term investors and corporate executives alike.

Adam

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

Related posts:
Grantham & Buffett: "Career Risk" & "The Institutional Imperative"
Buffett on "The Institutional Imperative"
Buffett: A Portrait of Business Discipline
Buffett on Bold & Imaginative Accounting
---
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 are never a recommendation to buy or sell anything.

Charlie Munger at Harvard-Westlake 2010

Aesop's Investment Axiom

According to Warren Buffett, the formula for valuing an asset purchased for gain is the same now as it was when articulated by Aesop long ago.

From the 2000 Berkshire Hathaway (BRKa) shareholder letter:

"...Aesop and his enduring, though somewhat incomplete, investment insight was 'a bird in the hand is worth two in the bush.' To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush -- and the maximum number of the birds you now possess that should be offered for it. And, of course, don't literally think birds. Think dollars.

Aesop's investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota -- nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.

Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to 'growth' and 'value' styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component -- usually a plus, sometimes a minus -- in the value equation."

Somehow a distinction between growth investing and value investing is frequently still made.

It's a distinction without a real difference.

Some will no doubt disagree.

Investing well over the long run requires many things, of course. Yet it ultimately depends upon understanding how to judge correctly, within a useful range, what something is worth -- regardless of its growth profile -- then paying an appropriate discount for it.

The necessity for a discount reflects the inherently imprecise nature of judging value. It also reflects the fact that not everything that's important can be known and misjudgments will inevitably be made. Simplistic valuation metrics like price to earnings are only useful if they happen to be a meaningful proxy for the amount of future net cash an investment will likely generate.

Unfortunately, that's often not the case.

More from the letter:

"...Aesop's proposition and the third variable -- that is, interest rates -- are simple, plugging in numbers for the other two variables is a difficult task. Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach. 

Usually, the range must be so wide that no useful conclusion can be reached. Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startlingly low in relation to value. (Let's call this phenomenon the IBT -- Inefficient Bush Theory.) To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a well-founded positive conclusion. But the investor does not need brilliance nor blinding insights."

How much cash will be generated, when it will generated, and what the prevailing risk-free interest rate is what's all-important. Once there's a meaningful estimate (within a range), the amount and timing of cash flows can then be discounted using an appropriate interest rate.

So it's not, as some might think, growth per se that's necessarily important.

If interest rates are very high, the cash produced in the future needs to be available to the investor sooner than later.

If prevailing rates are very low, the investor can afford to wait quite some time for that cash.

The investment process ultimately rests upon the foundation of knowing how to judge what something is worth consistently well. Lack that ability and everything built upon that foundation crumbles. Others skills and abilities won't be able to compensate for that shortcoming.

Otherwise, it comes down to thinking independently, an even temperament, discipline, and an awareness of limitations. It's less about IQ than some seem to think.

A speculator will, of course, have an entirely different way of looking at this. For a speculator (with a long position, of course), a large drop in the price of an asset is not a good thing. For an investor, a large drop in the value of an asset is not a good thing.

A drop in value means that the net cash to be produced over the life of an asset was misjudged.

A drop in price may mean the psychology of the market has changed (though it surely could also reflect fundamental factors). A temporary drop in price will be a good thing for the investor who's judged value well.

Speculators try to gauge price action. In general, they try to figure out what someone else will be willing to pay in the future.*

That certainly doesn't mean there's something inherently wrong with speculation. There isn't.

It's just that there is a real difference -- in both required skill set and temperament -- between trying to figure out what others will pay for an asset at some later time, and figuring out what an asset itself can produce over its useful life in economic value.

From this interview with Warren Buffett:

"Basically, it's subjective, but in investment attitude you look at the asset itself to produce the return. So if I buy a farm and I expect it to produce $80 an acre for me in terms of its revenue from corn, soybeans etc. and it cost me $600. I'm looking at the return from the farm itself. I'm not looking at the price of the farm every day or every week or every year. On the other hand if I buy a stock and I hope it goes up next week, to me that's pure speculation."

Let's hope we don't always have to go back 2,600 years or so to find investment wisdom.

Adam

Long position in BRKb established at much lower than recent prices

Related posts:
Aesop's Investment Axiom Revisited - Jul 2014 (Follow up)
Grantham: Investing in a Low-Growth World - Feb 2013
Buffett: Stocks, Bonds, and Coupons - Jan 2013
Maximizing Per-Share Value - Oct 2012
Death of Equities Greatly Exaggerated - Aug 2012
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on Aesop's Formula for Value - Nov 2009
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009

* This doesn't mean no fundamental factors influence a speculator's decision. The difference between investment and speculation is subjective -- far from black and white -- but still very real. It's a matter of proportion, emphasis, and time horizon. Investment and speculation can be considered similar only if one's definition of similar is rather imprecise.
---
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.

Buffett: Stocks, Bonds, and Coupons

In the 1992 Berkshire Hathaway (BRKa) shareholder letter, there's a condensed version of how John Burr Williams described the equation for value in his book The Theory of Investment Value back in the 1938.*

Warren Buffett explained it as follows in the letter:

"In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset."

Notably, as Buffett highlights, the formula is the same for stocks and bonds. The key difference being that bonds generally have future cash flows defined by the coupon and maturity date unless there's a default of some kind. In contrast, the equity 'coupons' have to be estimated by the investor.

"...in the case of equities, the investment analyst must himself estimate the future 'coupons.'"

The size and duration of those 'coupons' have a much wider range of possibilities. More from the letter:

"The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value. Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought.

Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite..."

It's easy to overly complicate the investment process, but it pretty much comes down to consistently paying comfortably less than the appropriately discounted present value of future cash flows. In other words, paying less than a well-judged conservative estimate of intrinsic value.**

If an investor is highly confident in their future cash flows estimate (and the appropriate interest rate to use), then a smaller discount would be necessary.

Still, requiring that an appropriate discount to value exists (margin of safety) is all-important to protect the investor against the unforeseen and unforeseeable.

Buffett's "irrespective of whether the business grows or doesn't" comment is worth noting.
(A subject I've covered quite a lot, if nothing else, on this blog.)

Some take it as a given that growth is of primary importance in investing. Well, for example, if $ 1 of earnings in perpetuity can be bought for $ 3, should the investor care if it grows? That's an extreme example, but sometimes the blind pursuit of growth leads an investor to take more risk than necessary to achieve a similar or worse result.

In fact, listen to enough commentary on investing and it seems growth dominates the conversation. That all growth is good growth is, at least, implied. I mean, how could growth not be a good thing, right? Growth is fine if it's of the high return variety and can be bought at a fair price. Unfortunately, many forms of growth do not produce attractive returns and can even destroy value. From the 2000 Berkshire Hathaway shareholder letter:

"Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years."

Attractive growth prospects usually sell for a premium. Too often -- even if growth happens to be in a potentially high return form -- the premium price paid means that permanent capital loss is more likely to occur if things do not pan out as expected.

Insufficient margin of safety.

Growth will, of course, often have a favorable impact on value. It just happens to be a mistake to think that it always has a favorable impact.

Many very fine investments have modest to no growth at all while having more predictable outcomes. Lacking excitement, they more often sell cheap. Their relative predictability also means that getting the investment analysis consistently right is more doable. In contrast, where there's high growth often invites in competition and naturally less predictable long range outcomes. With lots more competition there's usually less certainty that the economics will remain attractive during the pursuit of that growth.

So whether the investor can roughly but meaningfully estimate the coupons a business will produce over a very long time frame is far more important than growth. Buffett points out that even for very experienced and able investors, it's still easy to get the estimate of future coupons very wrong.

How does Berkshire deal with that reality? One way is that they stick to what they understand. As Buffett explains, it's easier to get the estimate of future cash flows right with businesses that are "simple and stable"  compared to those that are "complex or subject to constant change". It is not about how much an investor knows. It's about an awareness of what they don't know.

Awareness of limitations.

"An investor needs to do very few things right as long as he or she avoids big mistakes."

The other way they deal with the problem is always buying with a margin of safety. To always pay a price that is substantially lower than their own estimated value of future cash flows.

Finally, as Buffett mentions in the quote above, the current price relative to earnings or book value -- whether seemingly very high or low -- often reveals little about business value. Though, it's worth noting, Buffett has said Berkshire's book value is a rough if quite understated way to gauge the company's intrinsic value. Otherwise, sometimes what seems a low price against current earnings or book value won't turn out to be cheap at all. The opposite is, of course, also true. The price has to be considered against the discounted long run stream of cash that will be generated over time. Sometimes those future cash flows are just too difficult to estimate. In those cases, it's best to avoid the investment no matter how compelling the story is or cheap it appears.

Judging value based upon some simple snapshot measurement will often lead to very big and costly mistakes.

Adam

Long position in BRKb established at much lower than recent prices

Related posts:
Maximizing Per-Share Value - Oct 2012
Death of Equities Greatly Exaggerated - Aug 2012
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009

* First written as a Ph.D. thesis at Harvard in 1937.
** The Berkshire Hathaway owner's manual provides a useful explanation of intrinsic value.
---
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.

Buffett On A Depressed Stock Market

From the Berkshire Hathaway (BRKa) owner's manual:

"...a depressed stock market is likely to present us with significant advantages. For one thing, it tends to reduce the prices at which entire companies become available for purchase. Second, a depressed market makes it easier for our insurance companies to buy small pieces of wonderful businesses – including additional pieces of businesses we already own – at attractive prices. And third, some of those same wonderful businesses, such as Coca-Cola, are consistent buyers of their own shares, which means that they, and we, gain from the cheaper prices at which they can buy."

Every now and then I re-read the Berkshire owner's manual.

Bet that sounds like fun. Okay, maybe not, but there's much to be learned from it.

Whenever I do re-read it, I come away thinking how helpful it would be if more public companies had their business principles laid out in such a manner.

So it may not sound like all that much fun but it's only six pages long, it's a pretty quick read, and, at least to me, rather useful.
(It certainly requires less time and effort than a typical Berkshire shareholder letter.)

The excerpt is from number 4 of the 15 principles. Toward the end, there's also a good explanation of intrinsic value.

Well worth reading.

The above is not unlike what Warren Buffett wrote in the 1997 Berkshire Hathaway shareholder letter:

"If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices."

The typical initial reaction to a stock dropping in price is obviously a rather visceral one. So it takes some work to unlearn such an instinctive response. This may not be an easy thing to do, but it starts with having justifiably high confidence in one's own ability to judge business values consistently well, and the discipline to require an appropriate margin of safety.

Judge value well, buy cheap.

In other words, it's not possible (nor is it wise) to react favorably to a drop in price if the investor has an inflated appraisal of his/her own ability to judge intrinsic business value and they tend to pay too much.

Like many things it's an awareness of limits. Overconfidence and overestimation can be the real destroyer of long-term returns.

Adam

Long position in BRKb established at much lower than recent prices
---
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.