By the way, these letters are all available for free online, but I was happy to spend a little money and have some of the wisdom distilled for me.
On, then, to the themes:
Cunningham's book starts with the following two quotes:
"The speech I love is a simple, natural speech/ the same on paper as in the mouth/ a speech succulent and sinewy, brief and compressed/ not so much dainty and well-combed as vehement and brusque." - Michel de Montaigne
"The sincerity and marrow of the man reaches to his sentences. I know not anywhere a book that seems less written. Cut these words and they would bleed; they are vascular and alive." - Ralph Waldo Emerson
These may seem like odd choices to begin a book on an investor, but Cunningham knows what he's doing. It's impossible to ignore the clarity of Buffett's writing and thinking (not to mention the considerable wit that shines through). This was reinforced as I was reading Mohnish Pabrai's excellent "Dhandho Investor" (which will be the subject of a later post, when I finally get around to it). Pabrai draws a parallel between Einstein and Buffett (though even Buffett would surely be a bit embarrassed to be compared to Einstein). Pabrai writes, "Einstein noted that the five ascending levels of intellect were, "Smart, Intelligent, Brilliant, Genius, Simple." For Einstein, simplicity was simply the highest level of intellect. Everything about Warren Buffett's investment style is simple. It is the thinkers like Einstein and Buffett, who fixate on simplicity, who triumph."
One example of this simplicity is Buffett's concept of owner earnings, which is basically normalized free cash flow to equity. While I have used a similar concept in my own analyses, I used a much uglier phrase that I masked with an equally ugly acronym (so ugly that I'll spare readers!). The use of the simpler "owner earnings" cuts to the heart of the analysis, and to the heart of the valuation question.
Some make the grave error of confusing the simple with the simplistic. This error runs in both directions. Some are unable to see the beauty and resilience of simple ideas, preferring the complex and fragile. Others may cling to simplistic but sub-optimal ways of thinking. It's a challenge to cull extraneous ideas while retaining the essential.
In addition, Buffett's simple, clear writing suggests a level of comfort with himself. This mirrors his investment style - admittedly shaped over a long, successful career. As I elaborate below, there is a tension between finding one's own style and absorbing the lessons of great professionals.
Another focus is on building the right organization. As Buffett writes, "We have carefully designed both the company and our jobs so that we do things we enjoy with people we like." There are two levels to this. The first is relying on top-notch lieutenants at Berkshire. Hathaway. Berkshire is a massive operation, and it again requires a kind of simplicity to have it run effectively. Several quotes illuminate Buffet's thinking on this.
- "Having first-rate people on the team is more important than designing hierarchies and clarifying who reports to whom about what and at what times."
- He also quotes David Ogilvy: "If each of us hires people who are smaller than we are, we shall become a company of dwarfs But, if each of us hired people who are bigger than we are, we shall become a company of giants."
Most of us will never run entities on the scale of Berkshire (nor would most of us want to!). But there is another set of stakeholders with whom to build relationships, i.e. underlying investors. Buffett makes abundantly clear the immense amount of thought that has gone into attracting the right investor base at Berkshire. An investor base out of sync with the manager's philosophy is a recipe for disaster and unhappiness.
Suffice to say, the end result for Buffett has been overwhelmingly positive: "To almost a sinful degree, we enjoy our work as managing partners." Furthermore, "we enjoy the process far more than the proceeds - though we have learned to live with those also."
Elements of Buffet's Investing Philosophy
There is a lot of specific detail to be gleaned from the letters, but I'll focus on broader lessons. Perhaps the best expression of Buffett's philosophy is as follows: "In my opinion, investment success will not be produced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace." I liked that quote because it encapsulated various sub-themes:
a) Humility - knowing one's limitations
-"Charlie and I decided long ago that in an investment lifetime it's too hard to make hundreds of smart decisions."
- "by confining himself to a relatively few, easy-to-understand cases, a reasonably intelligent, informed and diligent person can judge investment risks with a useful degree of accuracy"
- Buffett quotes Keynes: "As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one's risk by spreading too much between enterprises about which one knows little and has no reason for special confidence. One's knowledge and experience are definitely limited and and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence." Keynes was hardly known for his humility, so these musings are worth taking seriously.
- "What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know. An investor needs to do very few things right as long as he or she avoids big mistakes."
- "we favor businesses and industries unlikely to experience major change"..."If others claim predictive skill in [fast-changing] industries - and seem to have their claims validate by the behavior of the stock market - we neither envy nor emulate them."
This humility is often a hard-won lesson from making errors. But a devotion to learning from one's mistakes is essential:
- "It's a good idea to review past mistakes before committing new ones".
- "A prime rule of investing: You don't have to make it back the way that you lost it."
b) Contrarian thinking, i.e. doing things that are unfashionable
On the one hand, it's an expression of humility to avoid popular areas where one has no comparative advantage. On the other hand, it's an act of striking confidence in one's own path to ignore the herd's collective drive.
- "as happens in Wall Street all too often, what the wise do in the beginning, fools do in the end"
- "the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs."
- "if [investors] insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."
One of the most contrarian things in the world of investment management is to do nothing:
- "Inactivity strikes us as intelligent behavior."
- "Lethargy bordering on sloth remains the cornerstone of our investment style."
Yet this seeming indolence is but preparation for a time of energy and activity:
- "during the episodes of financial chaos that occasionally erupt in our economy, we will be equipped both financially and emotionally to play offense while others scramble for survival."
- Buffett acknowledges that this is easier said than done: "Unlike [baseball player Ted Williams], we can't be called out if we resist three pitches that are barely in the strike zone; nevertheless, just standing there, day after day, with my bat on my shoulder is not my idea of fun."
While the power of the value investing framework speaks deeply to me, dogmatic interpretations of Buffett's record always annoy me. It's clear that one can be simplistic, not simple, when trying to characterize his success. Flexibility has been an important quality.
- One example is Buffett's early foray into arbitrage at Rockwood & Co., unlocking the hidden value of inventory (cocoa beans) despite the company's operating losses. As Buffett remarks succinctly, "Sometimes there is more to stock valuation than price-earnings ratios."
-"An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style. He can earn them only by carefully evaluating facts and continuously exercising discipline."
d) The uses and abuses of quantitative methods
Buffett is terrifically numerate, and from all accounts, an outstanding judge of the risk-reward trade-off. Yet he is selective when using numbers in his investment process:
- "the difficulty of precisely quantifying [the primary factors in investment analysis] does not negate their importance nor is it insuperable."
- "Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach. Calculations of intrinsic value, though all-important, are necessarily imprecise and often seriously wrong. The more uncertain the future of a business, the more possibility there is that the calculation will be wildly off-base."
The importance of equanimity in investing is something close to my heart, shown by previous posts. Buffett agrees on its importance as a component of a skilled investment mind:
- "We need someone genetically programmed to recognize and avoid serious risks, including those never before encountered...Temperament is also important. Independent thinking, emotional stability, and a keen understanding of both human and institutional behavior is vital to long-term investment success."
Keep calm, Buffett disciples, but I have to disagree with him here. Perhaps it's unfair to hold him to the turn of phrase, but surely one doesn't need to be "genetically programmed" to follow the investment path he espouses. I recently heard a fascinating 2-part interview with Dr. Ed Taub (see here and here) on Constraint-Induced Movement Therapy (CI Therapy). CI Therapy is a revolutionary approach to physical rehabilitation for stroke and other central nervous system injuries. Based on the principles of brain plasticity, it has several components, of which the most important are (a) repetitive, task-oriented training and (b) the transfer package, i.e. adherence-enhancing behavioural strategies. The parallels with investing are clear. For those lacking Buffett's preternatural "genetic" gifts, hard work and dedication to the investing craft are the next best thing.
With some luck, there will be more posts on Buffett's disciples in the following weeks.