David Barr, Felix Narhi and eight Pender colleagues had the opportunity to attend the recent Berkshire Hathaway Annual Meeting in Omaha. A chance to hear first-hand from two of our value investing icons, Warren Buffett and his partner, Charlie Munger.
The event not only reinforced our belief in value investing, but left us feeling inspired and more passionate than ever about this tried and tested approach.
The weekend also saw Markel Corp host their annual investor gathering. Markel is an insurance company that is successfully following the footsteps of Berkshire Hathaway. It is a core holding in the Pender US All Cap Equity Fund.
Here are the things that struck us the most, with our further thoughts on these topics highlighted in italics below.
BERKSHIRE HATHAWAY ANNUAL MEETING
When asked about one of their favourite businesses, See’s Candy, Buffett focused on the intellectual benefits of having owned a great business rather than just the monetary rewards of that particular investment. As Munger put it, “See’s helped remove ignorance at Berkshire”. See’s was a fabulous investment for Berkshire Hathaway, but Buffett almost decided against it because he believed the business was valued at levels too high to generate an attractive return. Until the See’s experience, Buffett was too rigid in his investment discipline, focusing mainly on very cheap stocks and remaining ignorant about the great potential returns from buying high quality companies at fair prices. Indeed, Buffett has admitted that “See’s opened my eyes to the power of brands. We probably made a lot of money in Coke because we OWNED a brand in See’s. We bought See’s in 1972 and bought Coke stock in 1988. I think they were connected.” As Munger humorously observed, “We were barely smart enough to buy See’s”.
Virtually all “value” investors start their journey in a quantitative process, seeking to buy stocks based on statistical cheapness. Low price-to-book and low P/E stocks are favoured with little regard for the quality of management or the business itself. Buffett started out like this and so did we. In doing so we missed opportunities that we otherwise should have considered as part of an intelligent investing framework. By studying outstanding investors, like Buffett, and embracing new perspectives when backed by empirical validation, we continue to improve and grow as investors. Ignorance removal should be a lifelong goal of both thoughtful investors and citizens – the more ignorance that can be removed, the better the potential outcomes.
“Scrambling out of mistakes”
When asked about how technology might disrupt some of the businesses in the portfolio, Buffett said that “all businesses should think about what can mess up their business model”. Although the businesses they chose “generally start from strength”, they have still found themselves having to jump ship. “We bought a department store in 1960s in Baltimore. We put in $6million but sold it before it went broke. That $6million became $45billion in Berkshire Hathaway Inc. value.” To quote Munger, “Ignorance removal is big. So is scrambling out of mistakes.”
To hear 83 year old Warren Buffett and 90 year old Charlie Munger talking about the perpetual process of learning is humbling and heartening. To us, investing, and value investing in particular, is very much an accumulated wisdom of lessons. The more you invest the more lessons you learn. You learn some hard lessons and you learn some fun lessons. You learn from the tough ones and strive not to repeat those and the good lessons serve as the mental models and the frameworks for investment success going forward. Of course we always hope to learn from the mistakes of others. They are the most cost effective! Still, the ability to admit you made a mistake and move on is very helpful to longer term results. You don’t need to make your money back the same way you lost it. Investors need to accept that making mistakes is an inevitable part of the investment process. The only unforgivable mistakes when investing are the ones that you don’t learn from.
“Cost of Capital”
Warren Buffett said “I’ve listened to so many nonsensical cost of capital discussions.” Both Buffett and Munger “just don’t use” the term cost of capital – “It means different things to different people”. When it comes to assessing an investment, they prefer to look at the opportunity cost – the potential return on their second best idea as compared to the return they are already getting on their first idea – “whether $1 we retain creates more than $1 of market value”. “A bird in the hand is worth two in the bush” to quote Buffett quoting Aesop. If it’s not better, then just buy more of your first idea.
We avoid complicated Weighted Average Cost of Capital (WACC) calculations and try to put more money into our best ideas which should generate the highest returns. This translates into not building a portfolio of 100 mediocre ideas but managing a concentrated portfolio of 10-20 “best” ideas. We think it’s crazy to put money into your hundredth best idea. We don’t know anyone who has a hundred good ideas. If you look at the amount of time and energy it takes to uncover a great investment opportunity when you find a great one, put your money into it.
“Circle of Competence”
Understanding the boundaries of one’s circle of competence requires being self-realistic. Buffett admits to being outside his circle of competence when he bought Berkshire Hathaway as a stock, but he was lucky to scrabble out of his mistake by allocating the cash flows from the dying textile mill to more productive assets that he understood better. According to Munger finding your circle of competence is not “too hard. If you’re 5’2”, you probably won’t make it in the NBA. Competency is a relative concept.” You need to find something where you are much better than your competitor. As Munger wryly observed, “What I need to get ahead is to compete against idiots. Luckily there’s a large supply.”
Knowing where your strengths are is an advantage in and of itself. And this is far from a limiting factor – in fact operating within your circle of competence gives you an edge, so long as you are clear on the boundaries. Getting to fulfil your passion everyday through your work, as we do, inevitably makes you better at your job. Interest fuels your activity level and dedication, and the more you learn the more competent you become. So while some investment firms constrain managers to build portfolios of a certain profile, our portfolios are different for no other reason than they contain the companies we are most interested in, do the most research on and consequently have greatest expertise from which to invest confidently. To quote Tom Watson Sr., founder of IBM, “I’m no genius. I’m smart in spots – but I stay around those spots.”
You can find various transcripts and commentaries on the Berkshire Hathaway meeting on the internet. We referred to www.valuewalk.com in compiling this.
MARKEL ANNUAL MEETING
“Why don’t you get more copy cats?”
Munger said that the Berkshire Hathway model is just very hard to copy and extremely hard to do. There is nothing in American business schools that teaches the Berkshire Hathaway way. Buffett said the other problem is that Berkshire’s strategy takes a long time and that probably deters people the most. Simply put, most investors are too impatient to implement Buffett and Munger’s strategy. This same question was asked at the Markel meeting. Steve Markel (Vice Chairman of Markel) said that most insurance executives grew up in insurance and not surprisingly, tend to be very conservative. (After all, we note that there usually are no positive surprises in the insurance business, only negative ones). As a result, they tend to fear the investment side of the business. To deal with this fear, they tend to outsource the investment side of the business which gives up control of one of the most compelling return driving attributes of an insurance company.
Markel has actively sought to copy Berkshire’s model since the late 1980s. Indeed, MKL’s 20-year track record from both a per-share book value growth (as a rough proxy for intrinsic value) and stock performance perspective is better than Berkshire’s and the S&P500. Insurance companies tend to be mediocre businesses, but they can be terrific investment vehicles in the hands of the competent capital allocators like Buffett and Tom Gayner (President and CIO of Markel). Cloning and learning from prosperous models is an efficient, rational and time proven way to become successful. This is largely what we seek to do as well as we invest your capital. Reinventing the wheel is inefficient and prone to lots of unnecessary mistakes. Why not absorb lessons from other successful long-term investors as much as possible? Also, it is important to be patient. Everyone wants to get rich quick, but very few get there because they have unrealistic expectations and take unnecessary risks which inevitably interrupt the compounding process. Wealth grown slowly also tends to be more enduring.
“Should I buy right now? Are the markets overvalued or undervalued?”
When it comes to predicting short term moves in the stock market, Gayner said that he believes with every fiber of his being that “there are two kinds of people in this world: Those that don’t know and those that don’t know that they don’t know.”
We tend to agree that no one has any idea what the stock markets or individual stock prices might do over the short term. One only needs to look at consensus estimates for market returns at the beginning of the year and compare them to the actual results at the end of the year to see how consistently wrong pundits tend to be over short periods. Moreover, empirical evidence has shown that consensus analysts’ estimates for earnings and target prices are also usually wildly off when compared to the future reality. Yet, the allure of forecasting short-term market moves remains highly seductive. After all, who doesn’t want to get rich? The quicker the better! Unfortunately, the world generally does not work that way. As Warren Buffett once said, “People who want to get rich quickly, will not get rich at all. There is nothing wrong with getting rich slowly.” Again, patience is the key to success.
Mass investor psychology tends to be biggest driver of the short-term movements of the stock market. Investors that trade frequently are reacting on noise of the constantly changing opinions of the investment crowd, not underlying fundamentals. There tends to be an inverse correlation between turnover and returns. In other words, patient investors tend to have better returns than the day trading types. The reality is that the intrinsic value of most large businesses does not change very much year to year. Yet stock prices generally fluctuate far more widely than fundamental value. Herein lies the opportunity. The good news is that eventually the underlying business fundamentals and the stock price will eventually meet. We focus on business fundamentals, generally over 3-5 year time horizons, and try to buy and own companies when we believe we are getting more value than we are paying for. As father of value investing Ben Graham observed long ago, “in the short run, the market is like a voting machine–tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine”. This has proven to be timeless wisdom. We believe investors will obtain better results if they remain patient and take the weighing machine approach.
David Barr and Felix Narhi, 8 May 2014