Learning from the Giant

Authors: Abhishek Gupta, Umang Khetan

The journey of becoming better, mature investors is incomplete without imbibing the pearls of wisdom that great investors scatter around us. The giant among them, Warren Buffet, writes each year a letter, primarily for the shareholders of his company, but no less relevant to anyone in the field of investing. We read a bunch of those and tried to capture the main learnings, along with some extracts for context, and also added our thoughts on those learnings. We hope you will enjoy reading, and find it relevant in today’s context.

Learnings from Warren Buffet letter to shareholders for the years, 2013, 2014 and 2015

1.     Analysing the worth of an investment: using the right metrics

Book value versus Intrinsic Value

It is very important to differentiate accounting methodology from one that makes more sense for investors; those adjustments are paramount to make the right inferences. In some cases, upward revisions to investment are not allowed so intrinsic value far exceeds book value. Thus, share price representing 1.X % of book value could also be cheap. Market value thus at times materially exceeds book value.

Example: Though Buffet sold no Kraft Heinz shares, GAAP required him to record a $6.8 billion write-up of the investment upon completion of a merger. That left him with Kraft Heinz holding carried on his balance sheet at a value many billions above the cost, and many billions below its market value, an outcome only an accountant could love.

Treatment of Depreciation

Using EBITDA as a valuation guide, is mostly not apt. The definition of coverage should be the ratio of EBIT to interest, not EBITDA/ interest, a commonly used measure Buffet views as seriously flawed. Depreciation is not consistent across businesses and needs to be accounted for. It is very important to understand the break-up of depreciation charges, specifically the capital outlay required each year.

Authors’ views:

A lot of market commentary and views are formed on metrics that don’t really matter for an investor. Most of the analysts and investors treat depreciation as a non-cash expense, and hence exclude it while coming down to a cash flow number, however, a business to run continuously requires to invest wisely in its PP&E.

Take a simple fact for example while doing valuation of a company using FCF method. We usually penalize the company for making capital outlays (FCF formula being, CFO – Net Capex – Net change in WC), while at the same time it’s responsible for the future growth of the company.

It’s very important to wear the investor hat and know the differences from wearing an accounting hat which the company has to wear for reporting.

2.     Finding moat in a business:

Productivity and prosperity are strongly linked but too few people grasp the linkage. At a macro level, GDP growth should be looked at from a perspective of how it increases per capita growth basis the rate of growth of population over a longer period of time. Similarly for a company, increases in productivity benefits is what helps a company increase margins, along with increase in scale. However, productivity gains frequently cause upheaval: Both capital and labour can pay a terrible price when innovation or new efficiencies upend their worlds.

Focus on the future productivity of the asset you are considering. If you don’t feel comfortable making a rough estimate of the asset’s future earnings, just forget it and move on.

Example: GEICO’s cost advantage is the factor that has enabled the company to gobble up market share year after year. (It ended 2015 with 11.4% of the market compared to 2.5% in 1995, when Berkshire acquired control of GEICO.) The company’s low costs create a moat – an enduring one – that competitors are unable to cross. Its rock-bottom prices add up to real money for pay check-strapped customers

Authors views:  

Moat is something that can be conveniently understood or replaced by “sustainable competitive advantage”. One has to make sure that’s it’s not only an advantage for the short term but what can be sustained. And a company making investments to achieve that, is supposed to be doing the right thing, as it will bring in the promise of healthy cash flows.

One other important thing is to see outcomes such as, revenue growth, increasing market share, increasing margins, sustainable high return on capital, as a proof to that advantage working well. It’s not only about the input but what output it results into.

3.     The Right Acquisitions

Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices, and own as much of it as possible. Warren’s biggest career mistake was to not buy enough of a fine business that he knew was fine. Have a passion to buy, build and hold large businesses that satisfy basic needs and desires. He encourages bolt-ons, if they are sensibly-priced. Such purchases deploy capital in operations that fit with the existing businesses, and that will be managed the corps of expert managers. That means no additional work for investors, and more earnings.

He prefers owning a non-controlling but substantial portion of a wonderful company to owning 100% of a so-so business. It’s better to have a partial interest in the Hope Diamond than to own all of a rhinestone. Also, it makes a lot of sense to increase ownership with time in what you believe are crown jewels of your portfolio and will continue to be so.

Example: One reason he was attracted to the Property/Casualty business was its financial characteristics: P/C insurers receive premiums upfront and pay claims later. This collect-now, pay-later model leaves P/C companies holding large sums – money we call “float” – that will eventually go to others. Meanwhile, insurers get to invest this float for their own benefit. As our business grows, so does our float. The nature of our insurance contracts is such that we can never be subject to immediate or near-term demands for sums that are of significance to our cash resources. This structure is by design and is a key component in the strength of Berkshire’s economic fortress.

Authors views:

While M&A is not a core strength area for the authors, diversifying or expanding through inorganic acquisitions is an important aspect for an investor to understand. The success of the transaction depends a lot on the reason behind going for diversification. In our experience, most of the decisions are taken on account of overconfidence due to success in core business, excess cash available, short term outlook to capture the on-going trend.

Moreover, when companies think about M&A, going for completely unrelated businesses, financing acquisitions through debt, and believing that a different management can run an already well functioning company better, the outcome could be far from expected.

4.     Sustainability and risk management

Warren repeatedly mentions companies that will do well a century from now.

It’s important for companies to identify and specify real risks that can help in evaluating the business. A threat that will only surface 50 years from now may be a problem for society, but it is not a financial problem for today’s investor.

It’s futile to forecast what will happen, given tomorrow is always uncertain. However, it always pays off to be prepared and armoured enough to take that opportunity, in case that comes. That is not being opportunistic but more of being conservative. It is madness to risk losing what you need in pursuing what you simply desire.

Example:

At a healthy business, cash is sometimes thought of as something to be minimized – as an unproductive asset that acts as a drag on such markers as return on equity. Cash, though, is to a business as oxygen is to an individual: never thought about when it is present, the only thing in mind when it is absent. At Berkshire, “breathing” went uninterrupted. Indeed, in a three-week period spanning late September and early October, it supplied $15.6 billion of fresh money to American businesses. It could do that because it always maintained at least $20 billion – and usually far more – in cash equivalents.

Authors views:

It’s one thing understanding risks and accounting for them. While it is important to understand them, not having the fire power or planning will tend to make the first action worthless. This is important both for an organisation and an investor.

Capital markets see irrational behaviour quite often. And then there are great investors such as Howard Marks who maintain cash, not because they cannot find enough opportunities to invest, but they know they will get better prices to enter into those securities. Ditto for a well-run company.

5. Expertise and understanding limitations

Reasonable investment returns are not a direct function of your expertise, it’s more about keeping it simple and understanding your limitations. One must however, be able to make a rough estimate of the asset’s future earnings, without which, one must let go of the asset and the opportunity. It’s important to accept that no one has the ability to evaluate every investment possibility.

Frequently, the best decision is to do nothing. There are worse things in life than having a prosperous business that one understands well. But sitting tight is seldom recommended by Wall Street. (Don’t ask the barber whether you need a haircut.)

Whatever anyone says, never forget that 2+2 will always equal 4. And when someone tells you how old-fashioned that math is --- zip up your wallet, take a vacation and come back in a few years to buy stocks at cheap prices.

Example: In 1986, I purchased a 400-acre farm, located 50 miles north of Omaha. It cost me $280,000, considerably less than what a failed bank had lent against the farm a few years earlier. I knew nothing about operating a farm. But I have a son who loves farming and I learned from him both how many bushels of corn and soybeans the farm would produce and what the operating expenses would be. From these estimates, I calculated the normalized return from the farm to then be about 10%. I also thought it was likely that productivity would improve over time and that crop prices would move higher as well. Both expectations proved out, with limited downside risk.

Authors views:

It was somewhere said, that, the most difficult strategy is the strategy to do nothing in capital markets. The more complicated the decision making becomes for an investment, the less confident one becomes about the investment. The more boring your investment strategy, the more sustainable it will be.

Moreover, because, people believe capital markets are an easy way to become rich, stock tips are very prevalent in the industry, especially for those people who want to avoid the hard work required into making investments. Experience of authors says, that one should completely avoid trying to make the quick buck, while also putting in intelligence and rationale into any investment.

6.     Speculation & need for focus

It’s important to focus on the future productivity of the asset one is considering, rather than focussing on the prospective price change of a contemplated purchase. Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game. And the fact that a given asset has appreciated in the recent past is never a reason to buy it. For most investors who speculate or are made to speculate by news channels, noisy neighbours, liquidity is transferred from the unqualified benefit it should be to a curse.

Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard.

Because there is so much chatter about markets, the economy, interest rates, price behaviour of stocks, etc., some investors believe it is important to listen to pundits – and, worse yet, important to consider acting upon their comments. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm.

Example: With my two small investments, I thought only of what the properties would produce and cared not at all about their daily valuations. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.

Authors views:

The ratio of time spent making an investment vs. tracking prices after making an investment, points to how one utilises his time. Someone who speculates more, spends most of the time tracking prices rather than understanding businesses and how they sell their products. He ends up buying speculative securities and not sustainable businesses.

7.     Capital allocation

There are often great obstacles to the rational movement of capital (& hence one must be rewarded when one is able to). A CEO with capital employed in a declining operation seldom elects to massively redeploy that capital into unrelated activities. A move of that kind would usually require that long-time associates be fired and mistakes be admitted.

Warren’s flexibility in capital allocation –willingness to invest large sums passively in non-controlled businesses – gives him a significant edge over companies that limit themselves to acquisitions they will operate. Woody Allen once explained that the advantage of being bi-sexual is that it doubles your chance of finding a date on Saturday night. With involvement in both operating business and passive investments, he can double the chances of finding use to deploy cash.

Example: At Berkshire, we can – without incurring taxes or much in the way of other costs – move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise. Moreover, we are free of historical biases created by lifelong association with a given industry and are not subject to pressures from colleagues having a vested interest in maintaining the status quo. That’s important: If horses had controlled investment decisions, there would have been no auto industry.

Authors views:

The key part of making a strategy is to close doors for some opportunities, rather than entering them. It’s usually said, the more number of times, one says no, defines how focussed, one is. This applies equally to investors for bad investments and companies for deploying capital in wrong businesses. Despite this, everyone, investors and organizations, makes mistakes, but, who succeeds in the long term is one who accepts them and tries to correct them, rather maintain status quo.

8.     Choosing the right CEO, and setting the right culture

Choosing the right CEO is all-important and is a subject that commands significant time. One thing that is more important apart from the character, is 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.

It’s important to select the people with the right motivations, and cultivating that in the culture of any organization. Moreover, for it to be effective, one has to lead from the top, and make it a case for someone to follow or ingrain.

It’s important for a company to maintain financial staying power which requires a company to maintain three strengths under all circumstances: (1) A large and reliable stream of earnings, (2) Massive liquid assets &, (3) No significant near-term cash requirements

Ignoring that last necessity is what usually leads companies to experience unexpected problems. Too often, CEOs of profitable companies feel they will always be able to refund maturing obligations, however, large these are. In 2008-2009, many managements learned how perilous that mind-set can be

Example: Character is crucial: A Berkshire CEO must be “all in” for the company, not for himself. A CEO’s behaviour has a huge impact on managers down the line: If it’s clear to them that shareholders’ interests are paramount to him, they will, with few exceptions, also embrace that way of thinking

Authors views:

It’s once said, that it’s more dangerous to invest in an unethical leadership and a great business, than in an ethical leadership and a mediocre business. Working towards the right objectives, of maximizing shareholder interest, is commonly asked for. But what does it take to do that, setting the right incentivizing and meritorious culture within the firm, where, people work for the right reasons and are motivated to do. How many companies does one actually know of that can be selected for a right culture? Do we screen for that before making our investments? A good food for thought.

9.     The Berkshire system

Key elements of the system established by Warren Buffett

(1) He particularly wanted continuous maximization of the rationality, skills, and devotion of the most important people in the system, starting with himself

(2) He wanted win/win results everywhere--in gaining loyalty by giving it, for instance

(3) He wanted decisions that maximized long-term results, seeking these from decision makers who usually stayed long enough in place to bear the consequences of decisions

(4) He wanted to minimize the bad effects that would almost inevitably come from a large bureaucracy at headquarters

(5) He wanted to personally contribute, like Professor Ben Graham, to the spread of wisdom attained

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.

Authors views:

Too immature to comment on what a right organization should be, but the above list seems like the ideal one to follow. Even if one can aspire for 50% of those, it should set up the organization on the path of growth, success and happiness. All 3 could be mutually exclusive.

Authors will be happy to hear your feedback, and make this more helpful, for the investing community. So it’s an earnest request to provide comments and feedback & we will aspire it to incorporate it our next article.