Berkshire Hathaway: Come For The Returns, Stay For The Philosophy

The release of Berkshire Hathaway's annual letter to shareholders is always a wonderful opportunity to learn from Warren Buffett. As usual, the letter has already been picked over by the media and blogosphere, but I wanted to record some of my own thoughts. This post can be read in tandem with an older piece I did on Buffett's shareholder essays. 

1) Simplicity. Buffett's letters are remarkable for their clarity. This is extremely unusual in a world where investment managers often aim to wow their clients with technical sophistication and jargon. Instead, with Buffett, we are left with the impression of someone who is able to take the complexities of investing and cut right to the core of the problem. Here's one example: Buffett notes that he and Munger expect Berkshire's normalized earning power to increase every year. This is a simple statement, but powerful in conveying that every investor can dramatically simplify his life and improve his returns by focusing on his portfolio's normalized earning power, rather than explicitly trying to generate high returns.

2) Dealing from strength. Buffett highlights Berkshire portfolio companies that pressed their advantage over competitors by making investments in new equipment. He notes, "Dealing from strength is one of Berkshire's enduring advantages." The source of strength is having dry powder when others don't, which requires patience and discipline. Buffett famously said, "Lethargy bordering on sloth is the cornerstone of our investment style." Similarly, there's a Munger quote that I love: "We don't mind long periods in which nothing happens...You look at [Buffett's] schedule sometimes and there's a haircut. Tuesday, haircut day." Instead of fretting about his portfolio, Buffett reveals that he spends ten hours a week playing bridge online - one way to combat boredom, which I've referred to in the past as the third emotion of investing. But of course the flipside of this is being aggressive when opportunities arise, and when competitors are unable or unwilling to act. 

Obviously, no-one sets out hoping to operate from a position of weakness, but prioritizing it as a strategic goal helps. As I've noted before, one of the mortal sins of investing is compounding earlier errors, and this typically happens when one is operating from a position of weakness and reacting to events in a haphazard fashion.

3) Business quality. For someone who is known as the doyen of value investing, Buffett makes surprisingly little mention of the prices paid for the businesses he purchased. Rather, he focuses on their quality. I'm not suggesting that Buffett ignores price; his discussion of insurance underwriting reveals, as always, a keen grasp of risk and reward, as does a note of caution on prices paid for bolt-on acquisitions. Nevertheless, his emphasis on quality, rather than cheapness, is telling. Despite his ability to be patient, Buffett is clearly not just waiting for cyclical lows. Unlike most investors who agonize endlessly over whether equities are cheap, Buffett continues to pour money into investments that he believes will pay off over the long run (Precision Castparts, Wells Fargo, Coca-Cola). 

4) Optimism. We're bombarded by soundbites from pundits (and truth be told, investors) who usually appear smarter for being negative. Buffett, on the other hand, comes across as unusually optimistic (a view shared by his friend, Bill Gates). Having a long-term horizon helps, but Buffett's success is supported by Dimson, Marsh and Staunton, who lauded the "Triumph of the Optimists".  

5) Come for the returns, stay for the philosophy. I'm guessing that most people start following Buffett and Munger because of the prospect of mimicking their investment success. I'm also willing to guess that most of those who stick around do so because they're attracted by the duo's integrity and life philosophy. In this year's letter, Buffett wrote, "There is no one more important to us than the shareholder of limited means who trusts us with a substantial portion of his savings." In a world of relentless asset-gathering masquerading as investing, Buffett's easy manner is why I, like many others, look forward to his letter year after year. 

Adventures In The Bargain Bin

I was at my local grocery store last week, and noticed that salmon fillets were 50% off. I stood in front of the display for a good two minutes, racked with indecision. I like salmon. It's usually more expensive than other meat, and it's rare to see it on sale. I vaguely recalled a Buffett quote about being happy to buy merchandise when it went on sale. And yet, I just couldn't bring myself to buy it. The fact that salmon is rarely on sale suggested to me it might not have been the freshest fish. Also, that store doesn't have the best reputation for selling the freshest meat & produce. And so I walked away.

I've written before that it's one thing to be a value investor, and another thing to be a cheapskate. But the salmon episode got me thinking: why couldn't I pull the trigger on what appeared to be something on sale? Two issues seemed key:

1) I couldn't be sure of the fish's quality. I looked up the Buffett quote when I got home: "Whether we're talking about socks or stocks, I like buying quality merchandise when it's marked down." The word "quality" is very important in that quote. The salmon price mark-down was in fact signalling something about the quality of the merchandise, and I didn't like the signal I was getting.

2) The consequences of being wrong could be deeply unpleasant. If you buy a cheap pair of socks and discover the elastic is already worn, the worst that happens is that you've wasted a few dollars and have to toss the socks in the trash. Not true of food, though: if the salmon had been less than fresh, it probably wouldn't have been life-threatening, but could easily have made me miserable for a day or two!

My adventures in the bargain bin have some clear implications for investing. Value-oriented investors are often drawn to stocks that have been beaten up, but it requires some genuine judgment to assess if price declines are warranted. Similarly, they may shy away from companies trading at lofty multiples, believing that valuations are excessive, even if the underlying company has excellent fundamentals. As with fish, this judgment depends on accurately evaluating the quality of the stocks and the consequences of being wrong.

Assessing quality is aided by the following:

a) Deep fundamental research. This should be a prerequisite, of course, but without this kind of work, it becomes far too tempting to use price as a signal of quality.

b) Stress testing/scenario analysis to understand if quality is genuine. I'm reminded of a great Ben Graham quote: "The risk of paying too high a price for good-quality stocks - while a real one - is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions. The purchasers view the current good earnings as equivalent to "earning power" and assume that prosperity is synonymous with safety." I suspect there are many investors in the natural resources complex who have become painfully aware of the truth of Graham's words over the past 12-18 months.

c) Long ownership or familiarity with a company/industry. Most people value a long-term investment horizon because when done right, it is easier to implement and more profitable than a trading strategy. As Phil Fisher wrote, "Finding the really outstanding companies and staying with them through all the fluctuations of a gyrating market proved far more profitable to far more people than did the more colorful practice of trying to buy them cheap and sell them dear." This long-term ownership, however, serves another important purpose. Over time, the analyst has the opportunity to observe the company through different economic conditions, and develops an understanding of its economic sensitivity.  Following a business for a long time reduces the risk that one will mistake cyclical earnings for true earnings power.

Finally, it's worth noting that one's willingness to take a risk should depend on the severity of a negative outcome. Socks with loose elastic are harmless, rotten fish less so. As Sanjay Bakshi points out in a wonderful speech, the eventual consequences of risk-seeking or risk-blind behaviour can be dire in many aspects of life. This is certainly true for one's long-term financial well-being. Sometimes, when something smells fishy, it's best to just walk away.

What Manchester United Can Learn from Yahoo

These are dark days for Manchester United fans. Darkness is relative, of course - the club remains an icon of sporting history, with a passionate fan base second to none. But, as the line from James goes, "if I hadn't seen such riches, I could live with being poor." The team's desperately abject performance in a loss to FC Midtjylland underscored the poverty fans have become accustomed to. For United fans, there is perhaps no greater fear than the looming possibility that a cycle of greatness has ended, and the club is on its way to become the new Liverpool - a mighty club rendered irrelevant, forced to watch as its great rivals chip away at its success. 

I spend a lot of my professional life trying to understand when sentiment has swung to extremes in financial markets, trying to be even-keeled when panic appears at odds with positive fundamentals. In an age when sports fans take to Twitter with vicious speed, demanding management and personnel changes at every little blip, my attempts to be sanguine are frequently challenged. While Man City's capture of Pep Guardiola is a knife to United's ambitions, I do think some are being too quick to anoint Guardiola's future City side as champions. But sometimes public opinion is spot on. I can't really explain why the Louis van Gaal era has shuddered to a halt so abruptly (to be honest, it never really gathered steam, despite the occasional flicker of promise). But it's safe to say the last few months have been truly hard to watch, both as a Manchester United fan, and a fan of the game. An excellent, if depressing, post by Paul Gunning perfectly captured my sentiments. And as the spectre of "Liverpoolisation" lurks ominously, I thought this week of another fallen giant of yore - Yahoo.

I'm not a tech analyst, so I haven't followed the demise of Yahoo in gruesome detail. All you need to know, however, is that the stock market currently ascribes negative value to Yahoo's core business. If that sounds crazy, here's a little piece by the New York Times explaining what that means. Basically, the stock market is saying that the only thing valuable about Yahoo is its stake in Chinese e-commerce behemoth Alibaba. Even if the market has gotten the valuation wrong, it's a damning indictment of Yahoo.

Where did Yahoo go wrong? Venture capitalist Paul Graham wrote a piece in 2010 taking a stab at the root causes. I highly recommend it - it's both short and fascinating. He identifies two major issues, easy money, and Yahoo's ambivalence about being a technology company.

First, the curse of easy money: "By 1998, Yahoo was the beneficiary of a de facto Ponzi scheme. Investors were excited about the Internet. One reason they were excited was Yahoo's revenue growth. So they invested in new Internet startups. The startups then used the money to buy [banner] ads on Yahoo to get traffic. Which caused yet more revenue growth for Yahoo, and further convinced investors the Internet was investing in." The story ends with Yahoo neglecting its search business because of its booming banner ad business. What it failed to realize was that the search business was far more sustainable, and that Google was eating its lunch there. 

This leads to Graham's second point, which was that Yahoo was ambivalent about being a technology company. Yahoo insisted on calling itself a media company, with negative consequences. "What Yahoo really needed to be was a technology company, and by trying to be something else, they ended up being something that was neither here nor there. That's why Yahoo as a company has never had a sharply defined identity...The worst consequence of trying to be a media company was that they didn't take programming seriously enough... In technology, once you have bad programmers, you're doomed."

Which brings us back to United. The club has increasingly positioned itself as a "global brand". Similar to Yahoo's loss of identity, Manchester United seems to have forgotten that it is first and foremost a football club. CEO Ed Woodward has proven himself adept at signing bumper commercial deals for the club. Yet the tail seems to be wagging the dog more and more. Recent reports suggest that Wayne Rooney could be on his way to China, assuming the club can "offset his potential departure with an eminent replacement their global partners would approve of to promote their products." Pause and let that sink in for a second. If that is true, it is diabolically misguided. The decision to replace a senior player should be driven entirely by footballing considerations. Yet Woodward's apparent obsession with "marquee players" seems to be spurred by commercial incentives, and possibly his desire to solidify his reputation as a deal-maker. A bit too much of the investment banker, then, about Woodward. 

Perhaps easy money has tainted United the way it tainted Yahoo. The circumstances are different, of course: this isn't the Internet bubble, and I'm sure Woodward works very hard to sign those commercial deals. But the focus on "global superstars" worthy of a "global brand" is unsustainable. Commercial partners appear to be salivating to capitalize on United's global cachet, but that won't last long if the club's leadership neglects the footballing core of the club. Furthermore, rather than hawking the brand at every turn, I believe it makes more sense to think of Manchester United as a luxury brand. The best luxury brands are obsessed with maintaining their aura, which is their greatest asset. Similarly, the fanatical support of a global fan base is a valuable asset that should be treated with the utmost care. I cringe when United players are forced to promote movies on their Twitter feeds. Don't get me wrong; I of all people understand there are commercial considerations. But Manchester United the commercial juggernaut is at serious risk of killing the golden goose that is Manchester United the football club that produced Charlton, Best and Law. 

Ultimately, there is only one group who can change the club's direction, and that is the Glazer family, who control its ownership. I've cautioned in the past about blaming the Glazers for all of United's ill fortune, while being critical of the club's ownership structure. But we've reached a crucial juncture for the club. While the Glazers may never understand the importance of the club to fans around the world, I can only hope they have an interest in protecting the long-term value of their investment. If they fail to grasp the seriousness of the situation, it may be a long time yet before United fans can reclaim the riches of the Alex Ferguson era.

Relationships as Emotional & Intellectual Diversification

In a recent post, I discussed some strategies for dealing with volatility in financial markets. I was reading a blog post by Robin Rifkin this week, and realized that I’d focused exclusively on what one could do at the individual level. Reading Rifkin, it became clear that a strategy I’d missed was to surround oneself with people who were able to be calm in the face of market vicissitudes. Finding a community of thoughtful investors should certainly be a priority – and this includes both the living and the “eminent dead”, as Charlie Munger calls them.

I almost wrote about finding a community of “like-minded investors”, though, and that struck me as a dangerous turn of phrase. I’ve written before about the risks of dogmatism and herding. In some ways, portfolio theory offers a useful analogy. A portfolio is improved by including assets that are uncorrelated. Similarly, one’s emotional and intellectual life is improved by diversity (within reason, of course. In a portfolio, you don’t want lack of correlation for its own sake – naturally, you want assets with positive future returns. In life, people who offer emotional and intellectual diversity may have other flaws that make it less worthwhile to associate with them. And of course the analogy has its limits. In portfolio theory, the Holy Grail is finding negatively correlated assets. If I had a friend who was delirious happy when I was very sad, I’d find that either rude or downright bizarre!)

So, to summarize: Rifkin is 100% correct that the right commentators and investors can provide a steadying hand during uncertain times, and he seems to have assembled a diverse group to lean on. The latter point is essential, and perhaps under-appreciated, in a world where we need relationships for emotional and intellectual diversification.

You Are Not Your Investments

Have you ever noticed that parents, especially those with small children, can be incredibly touchy? Reprimand their kids, and they quickly get huffy because they think you're criticizing their parenting indirectly. 

People are the same about investments. Bring up an investment that's gone badly, and 9 out of 10 investors quickly get very defensive. Same story - criticize the investment, and you're basically criticizing them. 

It's a natural reaction. In an old post, I called it a symbolic interactionist approach to investments. Humans act toward things on the basis of the meanings they ascribe to those things. The meaning of such things is derived from the social interaction that one has with others and society. Our investment decisions are tied up with our self-worth as investors, and our wealth is joined at the hip to our perception of social status.

But it's the wrong reaction. Jerry Goodman, aka Adam Smith, wrote about this in The Money Game. "A stock is, for all practical purposes, a piece of paper that sits in a bank vault. Most likely you will never see it. It may or may not have an Intrinsic Value; what it is worth on any given day depends on the confluence of buyers and sellers that day. The most important thing to realize is simplistic: The stock doesn't know you own it. All those marvelous things, or those terrible things, that you feel about a stock, or a list of stocks, or an amount of money represented by a list of stocks, all of these things are unreciprocated by the stock or the group of stocks. You can be in love if you want to, but that piece of paper doesn't love you, and unreciprocated love can turn into masochism, narcissism, or, even worse, market losses and unreciprocated hate." 

You are not your investments. Thinking otherwise puts us at risk of committing a mortal sin of investing, if we allow defensiveness to cloud our scrutiny of a prior decision. 

And by the way, the same logic should apply when your investments are doing great. Congratulations on the victory - but you're still not your investments. 

Mortal and Venial Sins in Investing

Financial markets have been roiled in 2016 on fears that China's economy continues to slow, and that the Fed will pursue a more hawkish tightening path than anticipated (the two are related, indirectly by the Fed's status as a monetary superpower, and directly by the RMB's link to the dollar). It has once again been a time to reflect on the challenges a fundamental investor faces. Macroeconomic concerns are hard to weigh when you're considering places like the US, and considerably more so when you're trying to assess an opaque economy in transition like China. So should an investor simply throw his hands up in the air?

I see a few potential strategies.

1. Learn all you can about macro. In his outstanding paper "Investing in the Unknown and Unknowable", Richard Zeckhauser notes the outsize returns to investors who can marshal complementary skills. Being a sophisticated macro observer has always seemed to me one such complementary skill. Some of the greatest trades of all time incorporate macro elements, whether intended or not. But I suggest with this a fair amount of trepidation. First, much of macro is unpredictable, and the product of a complex adaptive system, so it seems like a poor use of time trying to analyze it. Second, even where macro knowledge is helpful, there is a trade-off of time spent on macro analysis vs. asset-level analysis (such as knowing more about a company whose stock you own). Third, an excessive focus on macro fluctuations can lead to distraction from long-term trends, and prevent fundamental investors from appreciating the positive outlook for assets. So, perhaps the best idea is to focus on understanding the long-term drivers of economic growth, and to avoid being swept up by emotion during cyclical booms and busts. 

2. Invest in assets that are relatively insensitive to economic fluctuations. There are two variants of this strategy. The first is to invest in assets whose prices are relatively stable. This will likely lead an investor into low return strategies like investing in government bonds. For obvious reasons, I don't recommend this, even if it will help you sleep better at night! The second variant is to look for assets whose prospects are relatively bounded in a variety of economic scenarios (note there is often a great deal of overlap between these two variants: it is precisely their occasional divergence that is worth exploiting). The traditional version of this is to invest in various types of utilities. But there are obviously many high quality businesses out there who are resilient to most economic downturns, through a combination of competitive positioning and financial strength. These businesses generally trade at premium valuations (i.e. with low implied returns) for that reason, so when they go on sale, it's best to be prepared to act swiftly.

3. Be realistic. Understand that there will be ups and downs in any portfolio. Just as important, one has to differentiate between forgivable and unforgivable mistakes. Or, to draw a parallel to Roman Catholicism, we should differentiate between venial and mortal sins in investing. Charlie Munger has a great quote: "I like people admitting they were complete stupid horses' asses. I know I'll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn." But there's a limit to how harsh we should be with ourselves. I'm constantly wary of being a pattern-seeking, story-telling animal. It's okay not to know whether Chinese growth will be 3% or 6%. It is much less okay to lose money on a company that is modestly cheap if Chinese growth is 6% and in dire straits if growth is 3%. 

If I had to highlight one unforgivable sin in investing, it is getting swept up by emotion at market tops or bottoms (only identifiable in retrospect, unfortunately). But what's worse is that we have a tendency to compound these errors. It is really, really not okay to lose sight of the long-term prospects of a wonderful business, sell one's stake in that business, and compound that error by refusing to buy at a higher price. So, if you make a mistake, so be it - wipe the slate clean, lest a venial sin turn into a mortal one.

I wish all readers a happy, productive and - just maybe - sin-free 2016.

P.S. John Huber has an excellent post touching on some similar themes. 

Books I Enjoyed In 2015

The end of the year is rapidly approaching, and it looks unlikely I'm going to add to this list in the next few days. I modified this list somewhat from last year's in that I decided to include titles that I wasn't reading for the first time. I define "2015 Favourites" as books I can see myself re-reading, while "Honourable Mention" names are things I enjoyed but am unlikely to tackle again. Happy reading, and a very happy end to 2015 to one and all!

2015 Favourites

The Incredible Shrinking Alpha (Swedroe & Berkin): A quick and readable survey of the challenges facing active asset management. Anyone engaged in active management simply must grapple with these issues, as a matter of intellectual and professional honesty as well as to consider the business challenge posed by passive management strategies (be they indexers or rules-based quantitative strategies). Swedroe is a good follow on Twitter too.

The Greatest Trade Ever (Zuckerman): I have a longer post on this one, but it's just a terrific read to understand John Paulson's stupendous success in profiting from the housing debacle of 2007-2009. As I say in the other post, it's hard to write a page-turner about credit derivatives, but Zuckerman does an amazing job.

Efficiently Inefficient (Pedersen): This is a clear and entertaining read on hedge fund strategies. It features interviews with some of the leading lights in the hedge fund world, though I must confess I was a little disappointed with some of the interviews. The main material is excellent, though.

Becoming Human (Vanier): I first heard of Jean Vanier through an "On Being" interview. A philosopher and Catholic social innovator, he started the L'Arche movement for people with intellectual disabilities. His simplicity and compassion were deeply moving.

The Dhandho Investor (Pabrai): I have long heard of Pabrai's book, and finally got round to it this year. I wish I'd read it earlier. It's funny and readable, but a deeply wise book on value investing. His mantra of "Heads I win, tails I don't lose much!" is as good an explanation of how to think about achieving asymmetry in investing as you'll hear anywhere.

The Art of Charlie Chan Hock Chye (Liew): In a year when my beloved Singapore celebrated her 50th anniversary as an independent nation, this sharp graphic novel traces the country's history in parallel with a fictional graphic artist.

The Looming Tower (Wright): Everyone wanted to talk about ISIS this year, but I was a few steps behind. I bought this thinking it was an account of the 9/11 attacks, but it was much, much more. A wonderfully crisp read on the rise of modern Islamic fundamentalism and al-Qaeda.

The Outsiders (Thorndike): An excellent book on how contrarian CEOs created shareholder value, recommended by no less a luminary than Warren Buffett. It's a shame that most CEOs (and boards) think "capital allocation" = doing share buybacks when their stock is at record highs, rather than when it's the most accretive to shareholders.

Buddhism Without Beliefs (Batchelor): Batchelor is one of the giants of secular Buddhism, the movement that distills the wisdom of Buddhist thought while shedding traditional Buddhist ritual and beliefs on cosmology and reincarnation. In this volume, he makes a strong case for understanding the historical and social context in which Buddhism developed. As good as I remembered the second time round.

A Guide to the Good Life (Irvine): This is a wonderful introduction to Stoic philosophy, updating an obscure and misunderstood set of beliefs for modern times. The parallels between Stoicism and Buddhism are interesting, and goes to show you can find wisdom in disparate places if you look hard enough.

Superforecasting (Tetlock): Quite simply a must-read on decision-making and prediction. I think this is one I will read and refer to many, many more times.

The Alliance/ The Start-up of You (Hoffman/Casnocha): I enjoyed these two books by the LinkedIn founders. At times they seem a little too much like ads for LinkedIn, but I think there's a lot of wisdom in here about how to think about careers and organizations in the modern world.

The Essays of Warren Buffett: Buffett is so well-covered that it was hard to imagine that there would be much original in this collection, but I still found it useful and insightful. I did a longer post on the key messages.


Honourable Mention

Exorbitant Privilege (Eichengreen): It's really hard to write a book on the international monetary system for popular consumption. I think Eichengreen does a pretty good job here, although some may prefer a deeper look at specific events (e.g. Ahamed's Lords of Finance and Connolly's Rotten Heart of Europe). Reading it in 2015, it's funny how the book was written at a period of extreme concern about the dollar - something which seems to have vanished from the mainstream. But who knows what people will say in 5-10 years?

Poor Economics (Duflo & Banerjee): I've been hearing about Duflo & Banerjee's work for years, and enjoyed their take on the global fight against poverty. So much of what we think we know about poverty, and the poor, seems to be wrong, but it's gratifying to see people tackling the field in novel ways.

The Hard Thing About Hard Things: Entrepeneur and venture capitalist Ben Horowitz writes about his experiences in the business world. There are some great anecdotes and lessons here. Definitely one for those interested in start-up world.

Leaving Alexandria (Holloway): I've had this on my reading list for ages. In 2003 or so, I discovered a book called "Godless Morality", and was stunned to discover the author was the Bishop of Edinburgh. Since then I have been an avid consumer of Holloway's talks. This autobiography details his eventual departure from the church. While my thinking on religion is more in line with Holloway than Vanier, I preferred the simplicity of the latter's prose. Still, there was much to appreciate here.

The Novice (Schettini): Continuing the theme of those who had given up the robes, Schettini recounts his life as a Buddhist monk. Like Holloway's book, there was much to enjoy, even if the prose wasn't always quite to my taste. The epilogue was my favorite part of this, with Schettini describing the changes in his life after giving up the robes. A shame it's a relatively small part of the book, but it would be impossible to really understand without hearing first about his prior journey.

Benjamin Graham and the Power of Growth Stocks (Martin): This is an unusual take on Ben Graham as a growth investor. Martin argues that the 1962 edition of Security Analysis reveals Graham's shift in investment philosophy.

Damn Right! (Lowe): I hadn't read this since 2006, but decided to pick it up again as I re-explored the value investing classics. I found I enjoyed it less than I remembered. It's possible that Munger has become such a popular subject in the past 9 years that this edition no longer seems quite as original. Still, always worth a read for Buffett/Munger fans. And for those relatively new to the world of investments, it's a wonderful reminder that Munger didn't meet (and go into business with) Buffett till he was 36 years old, which seems positively ancient in the modern age of 30 year-old hedge fund wunderkinds.

The Education of a Value Investor (Spier): Part autobiography, part investment guidebook, part discourse on the good life. Spier's honesty was refreshing. This led me to Pabrai's book. The friendship between the two investors inspired a longer post as well.