Sunday, March 1, 2015

A few comments on the Berkshire Hathaway letter to shareholders

We got a nice treat this year with the “Golden Anniversary” letters included in the Berkshire report. While much of what was written had been mentioned by Buffett and Munger before, there were also new things, as well as some things that especially stood out to me that, while they may have been said to some extent before, made me think harder about than I previously remember.

One of those major things was the importance of reinvestment. And both Buffett and Munger's comments reminded me of this answer Tom Gayner gave at a Value Investor Conference last year:
Over the years, we’ve consistently discussed our four part investment process of searching for profitable businesses with good returns on capital, run by honest and talented management teams, with reinvestment opportunities [and] capital discipline, at fair prices. I believe that each and every word of that distilled statement packs incredible freight. As such, I’m reluctant to pick any single notion as more or less important than another. They all tie together.

That said, if you held a gun to my head and said which of the four ideas is most important, I would respond with point #3, reinvestment opportunities and capital discipline.

One of the reasons that I propose such a simplification is that the idea of reinvestment and capital discipline embeds the other concepts. If the business is not profitable, there is no money to reinvest. If the management team is not talented and honest, there will either be no money to reinvest or it will be hived off by the management before it ever gets to the shareholders. And finally, and this is the most nuanced and misunderstood aspect of investing, a fair price may be a lot more than you would think if profitable reinvestment really can take place.
Buffett made the point that having the flexibility to invest anywhere is one of the major advantages of Berkshire's conglomerate structure:
In effect, the world is Berkshire’s oyster – a world offering us a range of opportunities far beyond those realistically open to most companies. We are limited, of course, to businesses whose economic prospects we can evaluate. And that’s a serious limitation: Charlie and I have no idea what a great many companies will look like ten years from now. But that limitation is much smaller than that borne by an executive whose experience has been confined to a single industry. On top of that, we can profitably scale to a far larger size than the many businesses that are constrained by the limited potential of the single industry in which they operate.

I mentioned earlier that See’s Candy had produced huge earnings compared to its modest capital requirements. We would have loved, of course, to intelligently use those funds to expand our candy operation. But our many attempts to do so were largely futile. So, without incurring tax inefficiencies or frictional costs, we have used the excess funds generated by See’s to help purchase other businesses. If See’s had remained a stand-alone company, its earnings would have had to be distributed to investors to redeploy, sometimes after being heavily depleted by large taxes and, almost always, by significant frictional and agency costs.
And it also reminded me of something I have included in a file of investment reminders and thoughts that I keep around to review regularly. This is a particular reminder I have about compounders not just being businesses that can internally reinvest, but also management teams that have the flexibility to reinvest in other places:
Compounders can also be managers or investment teams that reinvest cash flows or float at a healthy rate of return, in a flexible manner…. But keep in mind that these are very hard to identify ahead of time, it can be easy to be fooled by people, and that a bad business can overwhelm even the best operators and capital allocators.
And as Buffett especially stressed in his letter, Berkshire was certainly a bad business when he took over. But besides the fact that he may have been, and continues to be, an extra special capital allocator, his drive (and maybe a little luck along the way) to continue to reinvest in himself and get a little wiser every day is what helped to propel Berkshire beyond the headwind of a bad business. And I think Munger made this point well when describing the system set up at Berkshire, whereas Chairman Buffett made sure that:
His first priority would be reservation of much time for quiet reading and thinking, particularly that which might advance his determined learning, no matter how old he became; and
He would also spend much time in enthusiastically admiring what others were accomplishing.
...When Buffett developed the Berkshire system, did he foresee all the benefits that followed? No. Buffett stumbled into some benefits through practice evolution. But, when he saw useful consequences, he strengthened their causes.
Munger then goes on to list many other factors which I won't rehash here, but they are so applicable to most businesses and other areas of life that they will be something I plan on revisiting often. And they include more thoughts on reinvestment, and in one case an example of missing out on investing in a company with a long road of reinvestment prospects in place:
What were the big mistakes made by Berkshire under Buffett? Well, while mistakes of commission were common, almost all huge errors were in not making a purchase, including not purchasing Walmart stock when that was sure to work out enormously well. The errors of omission were of much importance. Berkshire’s net worth would now be at least $50 billion higher if it had seized several opportunities it was not quite smart enough to recognize as virtually sure things.
One other comment from Buffett got me thinking about the commentary I had on diversification and the Kelly Formula recently:
I believe that the chance of permanent capital loss for patient Berkshire shareholders is as low as can be found among single-company investments. That’s because our per-share intrinsic business value is almost certain to advance over time.
This drove home the point to me of how much big position sizes are favored by good businesses that grow their per-share intrinsic business value over time. I mentioned I thought 6-12 position sizes is probably a good number of core positions for the value investor who puts significant effort in choosing his or her investments. Now, at the concentrated end of that, you'd have 16.67% position sizes if fully invested equally. If you're leaving some margin of safety for error, the unknown unknowns, or because of opportunity costs, maybe you're only "betting" 1/2 Kelly on a given position. Which means that you'd need a fully Kelly position to tell you that you should be putting 1/3 of your portfolio in something before committing 16.67% to it at 1/2 Kelly.

What upside vs. downside gives you that output? If you're assuming 50/50 odds of being right (which is hopefully conservative), then you'd need a 3x upside vs. downside ratio over your investing timeframe before investing. As we've seen and as Buffett and Munger stressed, even Berkshire has been about halved three times since 1965. And while that wasn't permanent of course, if you assume your downside on a given in investment is around 50%, then you'd need 150% of upside (i.e. more than a double) in order for that bet to be worth taking. And it's hard to find that kind of potential in a company that isn't growing its value over time. And if you take the potential downside to be complete loss of capital (i.e. 100% downside), then 150% of upside would give you a full Kelly position size equal to the 16.67% number, and a 1/2 Kelly position size then at 8.33%.

And the key to that growth being growth in per-share intrinsic business value because not all growth creates value, which was also shown, to some extent, in one example by Buffett of things that he, in his Buffett Partnership days as well as at Berkshire, hasn't done:
At both BPL and Berkshire, we have never invested in companies that are hell-bent on issuing shares. That behavior is one of the surest indicators of a promotion-minded management, weak accounting, a stock that is overpriced and – all too often – outright dishonesty.
And a final excerpt from Mr. Buffett, which is too good not to repeat:
My successor will need one other particular strength: the ability to fight off the ABCs of business decay, which are arrogance, bureaucracy and complacency. When these corporate cancers metastasize, even the strongest of companies can falter.