Felix Narhi and Ian Collins attended the recent Berkshire Hathaway Annual General Meeting in Omaha. As the company was celebrating the 50th year anniversary since Warren Buffett took management control, the mood was particularly festive with record attendance. As always, we enjoyed the opportunity to hear first-hand from two of our value investing icons, Warren Buffett and his partner, Charlie Munger. Here are the things that struck us the most, with our further thoughts on these topics highlighted in italics below.
“Always be open to good accidents” – Warren Buffett
When asked whether Buffett thinks he could repeat his success in insurance if he started all over again, he focused on the role of luck in many successful business outcomes and the importance of being open to ideas as they come along. The core economic engine of Berkshire’s incredible success over the last 50 years has been its insurance businesses. Without a few “good accidents” in Buffett’s career, combined with his willingness to act, Berkshire would look much different today. He specifically pointed to three lucky inflection points in his career that would be unlikely to happen again.
1) A lucky break to learn about insurance: At the age of 20, while attending the Columbia Business School, Buffett learned that his business professor and mentor Ben Graham owned a large stake in GEICO, an insurance company. Curious to learn more about this investment, Buffett went knocking on their office doors the following Saturday morning. Businesses were closed on Saturdays, but he got lucky when a janitor let him in and he was fortunate to meet the only person working there during the weekend, GEICO’s future president, Lorimer Davidson. Most senior executives would not have given a student the time of day, especially when they were attempting to get extra work done on the weekend. However, Buffett explained that he was a student of Graham’s and somehow persuaded Davidson to answer his questions about the insurance industry and GEICO over the next 4 hours. (Decades later, Berkshire would end up acquiring the entire company.) Without this initial accidental meeting with Davidson, Buffett would not have learned why insurance could be a great business and Berkshire might not have become the insurance company it is today.
2) Pouncing on a tiny window of opportunity: Berkshire bought its first insurance company National Indemnity in 1967 from its founder Jack Ringwalt. Although it was a great and well-run insurance business, Jack would occasionally “get mad for about 5 minutes” about some claim which made him want to sell the company. Upon hearing this, Buffett asked a friend who was on National’s board to let him know the next time Jack got into one of his selling moods. Inevitably, Jack got mad again and Buffett pounced on the opportunity to buy his initial business in the insurance sector. The $20 million of float that came with the 1967 purchase has now increased – both through internal growth and acquisitions – to $84 billion. Without Jack’s occasional mood swings and Buffett’s willingness to pounce on the opportunity before he could change his mind back, Berkshire might not have been the big insurance company it is today.
3) Unproven talent becomes a future insurance superstar: In the mid-1980s, Ajit Jain approached Buffett looking for work although he had never worked in the insurance business before. Buffett was impressed with Jain and decided to hire this unproven talent. Since then, Ajit has become so valuable to Berkshire that Buffett once wrote to shareholders that if he, his partner Charles Munger and his deputy Ajit Jain were ever on a sinking boat and only one of them could be saved, “swim to Ajit.” If Ajit had not walked into Buffett’s office that day, Berkshire’s insurance operations would be much smaller today.
Buffett did not have a master plan to create the world’s largest insurance company. He said “the whole thing in business is being opened to ideas as they come along” and got lucky that his initial “good accidents” were within the insurance sector. If his mentor Ben Graham had owned a large stake in Ford instead of GEICO, perhaps Berkshire might own an automotive company today. And what if the janitor hadn’t opened the door, or the senior executive hadn’t been inclined to talk? That said, Buffett commented that if he was starting all over again he probably would focus on something else besides insurance. We think many of life’s great outcomes are a result of someone seizing an opportunity which initially looked more like an “accident”. We have also seen the other side of the coin. While some people embrace “good accidents” as stepping stones for greater success, others see more of the downside risks and fail to act.
“Hardly anything is more important than behaving well as you go through life.” – Charlie Munger
A number of questions revolved around the subjects of reputation and culture. Maintaining a good reputation is very important and can only be built up over time, one grain of sand at a time. Buffett said he was once told that “When you get old, you will get the reputation you deserve” and said Berkshire has benefited a great deal from its reputation. Historically, Berkshire has focused on acquiring strong, well run businesses and has left the existing management in place. The idea of investing in “turnarounds” has never held much appeal at Berkshire. That may be slowly changing at least indirectly, if not directly (yet).
In recent years, Berkshire has increasingly partnered with 3G, a Brazilian led private equity group, who has established a strong track record generating high returns in the turnarounds of large, well-known companies. Berkshire’s involvement with this group was a source of a lot of questions and uneasiness amongst many in the crowd because their model is different to the one Berkshire has historically used.
3G typically buys controlling ownership of poorly run firms that have well-known brands (e.g. Heinz, Anheuser-Busch, Burger King) which can be turned around through “rightsizing”, eliminating waste, revamping the culture to be more performance orientated through better financial incentives, and recapitalization. Both Buffett and Munger defended 3G, sensibly arguing that all organizations need to be as efficient as possible. However, we think part of Berkshire’s “secret sauce” is its appeal to founders and family run organizations who want to sell to an owner like Berkshire who will leave them alone to run their business post-acquisition. They often sell at less than top dollar to Berkshire in exchange for this implicit promise. In turn, Berkshire gets an attractive price and strong management in place to continue running their organization. Where Berkshire seeks well run organizations to buy and leaves them alone, 3G buys poorly run businesses and then introduces their aggressive culture of performance. Berkshire does not have the skill set or DNA to take part in such major corporate reorganizations. How will prospective business sellers feel about Berkshire’s increased involvement with 3G? Will they be less willing sellers?
Berkshire is so large now that only true elephant-sized acquisitions will move its performance needle. Unfortunately, the valuations of publicly traded large companies have become increasingly pricey after the recent market run. It is hard to envision big further gains from valuation multiple expansion, especially if interest rates begin to inch higher. Most of the large companies that Berkshire would target operate in mature industries and already dominate their respective fields making it difficult to grow through further market share gains. Against such a backdrop, returns from organic growth will be modest. Barring another market correction, we believe one of the ways to generate above average returns from a group of fairly valued, slow growing companies is to use aggressive tactics like those employed by 3G. Whether investors believe these tactics are too aggressive or not, Berkshire’s growing association with 3G has the potential to change the perceptions (and the reputation) of both the company and Buffett. There are always tradeoffs that must be weighed. On balance, the 3G involvement makes sense for the reasons we outlined above but reputational issues must be considered. We agree with Munger’s “old fashioned principle” that the best way to earn trust is to deserve it by behaving well as you go through life.
“If people weren’t so often wrong, we wouldn’t be so rich.” – Charlie Munger
Someone asked Munger if Berkshire’s ownership of IBM was similar to owning value-destroying textile mills back when Buffett first took over Berkshire and whether he tried to talk Buffett out of it. Munger said he supported the purchase of IBM and noted that IBM was a very creditable company which had survived many transitions in the past, albeit it has fared through some cycles better than others. He said they owned a lot of companies in the past that have had temporary reversals (and they did just fine). Buffett said that many investors assume that they would want to talk up their book of investments when in fact the opposite behaviour makes more sense. Investors should want the price of securities they like to go down, not up, so they can buy more.
IBM has become a controversial holding for Berkshire because it has not worked out well so far. Whether or not IBM works out as envisioned, it is hard to argue with Buffett’s logic about stock prices. Assuming one will be a net saver over the medium-to-long term, it makes more sense to be happy about lower stock prices during the accumulation phase of life. Only those who plan to be net sellers of stock in the near future should be happy about rising prices. Even if investors do not directly buy more stock, they will benefit through increased ownership of a business if the company itself buys back its stock when prices are depressed. This is sound logic, but counterintuitive to many investors which prompted Munger to quip “If people weren’t so often wrong, we wouldn’t be so rich.” To be fair, Berkshire will likely always be in a position to be a net purchaser of assets because it generates a lot of recurring cash flows that need to be reinvested. Successful corporations can afford to take such a “net buyer” long view. On the other hand, time horizon on a human scale makes a big difference. A younger investor might be in a similar position as Berkshire (and should be happy about lower stock prices so they can buy more – although most are not), but older investors who no longer produce income from their labour and are living off their savings and accumulated capital would be in the opposite position.
“If we continue with these interest rates, stocks will look very cheap” – Warren Buffett
A question was asked about the general valuation levels of the stock market and whether it was overvalued. Specifically, Buffett was asked about his two historical favourite indicators of market valuation which are Market Cap-to-GDP and Corporate profits-to-GDP. Both measures suggest that US stock markets are overvalued. Buffett opined that today’s high valuations are due to the ultra-low interest rate environment which they thought would be almost impossible just a few years ago. At the end of the day, all investment opportunities must be weighed by opportunity costs.
If the main alternative to ownership of stocks are bonds with record low yields, then stocks will look relatively attractive. With respect to predicting tomorrow’s general stock price movements and interest rates, Charlie Munger countered “Since we failed to predict what is happening now, why would anyone ask about our opinion about the future?” Berkshire’s management team does not think about macro factors when making individual investment decisions. Munger said “We are swimming all the time and let the tide take us.” In other words, they keep looking for attractive investments irrespective of the macro environment. Berkshire bought its railroad BNSF in the midst of the financial crisis and it has been a terrific investment.
The S&P500’s valuation on metrics like the P/E ratio is not cheap by historic standards, but on the other hand, we are also living in a highly unusual period of incredibly low interest rates. P/E ratios are often evaluated on a static basic, but should be adjusted when there are meaningful changes in interest rates because of the opportunity costs involved. If interest rates go up a lot, today’s valuations will look dear. If they stay low, they will look cheap. We have nothing to add to Munger’s prediction comments. Nevertheless, whether the general market is cheap or not, at Pender we believe there will always individual opportunities within the market that are attractively priced because they are either ignored, misunderstood, or become cheap in periods of panic selling. The overall market was not cheap in 1999 either, but it was a two-tiered market of very expensive stocks (large blue chip stocks and technology/telecom-related) and attractively priced stocks (small cap and less glamorous businesses). Overall, attractively priced stocks did well despite the tough markets over the next decade. The market’s best opportunity set may change over time, but the interest rate environment will continue to have a heavy influence on all asset classes.
Felix Narhi, 5 May 2015
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