What did Warren Buffett and Charlie Munger make me reflect on this year?
This was my 20th shareholder meeting and each meeting brings new learnings. But I also keep building on the foundations of the previous years.
The risk when I write about it now is that I skip the hard yards I’ve done since the first meeting in 2000 to make it an easy read for you. I’ve resisted that temptation. Nobody ever did well in investments by taking short cuts. Over the years we’ve taken many CEOs and investors to the meeting who benefitted from attending – I hope you get something out of my thoughts on the points Buffett and Munger made this year.
- All investing is value investing.
When you invest you are trying to attach a value to future cash flows of a business. Where investors differ is how they value these cash flows. This comes back to understanding Aesop’s wisdom, ‘A bird in the hand is worth two in the bush’, which is essentially about how you deal with uncertainty. Buffett and Munger’s success lie in the fact that they have always:
- reduced the risk of valuing future cash flows by investing in what they know works best, namely a high return on capital investment with a moat, and
- made sure they understood what they were investing in, rather than by diversifying into what they didn’t understand or like (whether it be industries, businesses or countries).
- Assessing macro risks should form part of the risk assessment but shouldn’t be the focus. This is especially relevant when you have a long-term investment horizon. From the beginning, Buffett and Munger grasped that they’ll have far greater success spending time on identifying good companies run by good management teams than trying to do the impossible – forecasting macroeconomic variables. To paraphrase Buffett: ‘We know there will be good and bad years, but when you’re invested in a good business, don’t fret about the order in which the years will come.’
- Seven of Berkshire Hathaway’s top 10 holdings are financial companies.
Few people appear to have noticed this, and it illustrates how Buffett is prepared to go against popular convention and back his beliefs. Such a big investment in the financial sector might seem like a big ‘macro’ call, but it’s not. It is simply the result of points one and two above: investing in what he understands and where he has a high degree of certainty that shareholder value will grow above his hurdle rate, and acquiring this at an attractive valuation. (More about this in the discussion further down.)
- What about Google and Amazon?
Buffett’s view on them relates back to Aesop’s birds:
- When it comes to Google, they had enough information to be able to judge whether the business would do well. (‘We are ashamed. We had enough information via Geico and others as to the business model. We didn’t apply our mind and didn’t act.’)
- But in the case of Amazon: ‘We don’t blame ourselves for missing Amazon. It was not forecastable; Bezos is a miracle worker’. The bird in the bush was deemed too risky. They were not prepared to take the risk of investing in a business model that hadn’t yet proven itself.
- Private equity funds as an investment?
They were critical about the way the private equity industry has gone and the dishonest way of many when calculating and reporting Let the reader beware…
- Clear, simple and less can be more when it comes to communication with investors/shareholders.
Buffett’s views are noteworthy: ‘I write the shareholder letter with my sisters in mind. I try not to give them unnecessary detail. 50 years ago, I could have given investors a lot of info on the Berkshire Hathaway textile mills (detail about how each product was performing) and the reader would not have realised that the business was dying…So if I write a 300-page document, investors would be worse off than (with) a 50-page document.’ Besides, as he said, the more information provided, the less likely investors are to read it. We’re living in an age where regulators have gone totally overboard to protect, but this has become a real burden and unusable. Trust and judgement have been replaced by overprotective zealotry.
- The problem of size will make it increasingly difficult for them to maintain their track record of outperformance (refer later).
The shift in Berkshire Hathaway’s top 10 holdings
On 31 March 2019, the top 10 shares made up 80% of Berkshire Hathaway’s listed investments. The change in these top holdings are shown in the table below. Four points are particularly worth noting:
- The purchase of Apple, going from zero to number one.
- At the same time the selling of ‘old favourites’ – IBM and Walmart. I think the swop of IBM/Walmart into Apple was due to the influence of Ted and Tod. Buffett himself has always been a very loyal and patient investor.
- The swop of Munich Re and Goldman’s into Bank of America, JP Morgan and Bank of New York. (The purchase of Bank of America was effectively done in 2009 when Buffett provided funding and bought warrants that he exercised in 2017.)
- And then the point most people miss: despite Berkshire Hathaway’s already high exposure to the insurance industry (mostly short-term insurance), during 2018 they increased their investment in the financial sector to 7 out of their top 10 holdings. This is a big ‘bet’ indeed and again shows their ‘bottom-up’ investing philosophy.
Table 1: Swopping 5 of their top 10 holdings in three years is quite something!
|Berkshire Hathaway top 10 holdings (in their listed equity portfolio)|
|Dec – 16||Dec – 19|
|Coca-Cola||Bank of America|
|American Express||Wells Fargo|
|Procter & Gamble||US Bancorp|
|US Bancorp||JP Morgan|
|Munich Re||Bank of New York|
Source: Berkshire Hathaway
The top 10 again shows Buffett’s disdain for diversification for the sake of it (Munger calls this ‘diworsification’)
To my best knowledge, he has never held any resource shares (except a Chinese oil company a few years ago). I also don’t think I’ve seen any other fund manager with such a large investment in the financial sector.
Is the 70% exposure to financials purely a bottom-up view?
In my opinion yes, based on the following reasons:
- Buffett has always had a large listed and unlisted financials exposure regardless of the prevailing view on growth or interest rates.
- He was proven right when the well-run* financial companies came through the 2008 crisis very well. Sure, share prices fell +/-50% (for the long-term investor this doesn’t matter too much), but generally they grew shareholder value throughout (which does matter).
- For the 13 years from 2005 to 2018 Wells grew shareholder value at a compound rate of 13.9%, American Express at 12.6%, and JP Morgan at 14.1%.
Few investors realise the compounding power good financial companies have. The above period includes the credit crisis years and the worst market correction in 70 years!
Two important notes:
- Wells’ recent poor performance was due to incorrect incentivisation practices. It is interesting that it seems that neither Buffett nor Munger picked this up. However, I suppose the problem was at branch level, which higher level management should have picked up, but not necessarily Buffett and Munger.
- Bank of America did indeed need to be rescued in 2009 but that was due to several factors (acquisitions at the peak of the cycle being one of them) and its problems were very noticeable well before it started imploding. Buffett only invested in Bank of America after the crisis.
- Post the financial crisis the financial sector has been cleaned up and is stronger than ever before.
- Regulatory changes have enhanced the moats of financial companies and made it very difficult for new players to compete with the larger ones (except in niches).
- The financial sector currently presents investors with an ideal combination:
- shares that compound shareholder value at a high rate, and
- a sector that is at historically low valuations because of misplaced market fears. (valuations are close to end-2008 price/net asset value levels).
*We conducted an interesting research project that tested characteristics that were present in financial companies that came through crises well, and they mostly resemble what Buffett would look for in companies.
Should one ignore ‘the macro’ when investing internationally?
This is a topic on its own (on which we’ve also done quite a bit of research), and our answer is ‘no’. Good companies come through crises or turbulence well. But an important aspect of successful international stock picking is to assess the underlying macro forces. As my friend Pavel likes saying: ‘You want to invest with the tailwind of an economy going from socialism to capitalism; the headwind of the reverse makes it difficult for even the best companies to do well.’ (Not impossible though: Capitec is a good example). But in the case of e.g. Turkey or Argentina: very few Turkish or Argentinian companies generated dollar returns that beat the S&P over the past five years – certainly none in the financial space. Our research and experience have shown that when investing internationally, country selection does make a big difference.
The problem of size
Berkshire Hathaway has generated unbelievable returns over the past 52 years. Few fund managers come close to a 19.7% compound annual growth rate (CAGR) US dollar return over 10 years, let alone 20 or 50 years. But at the May 2019 meeting both Buffett and Munger stated a few times that Berkshire Hathaway’s size has become a headwind. Going forward, investors should invest in Berkshire Hathaway for the certainty of returns rather than their ability to create significant outperformance over the S&P index. Table 2 shows the following:
Berkshire Hathaway has continuously outperformed the MSCI World.
Table 2: Historical performance (net of fees) to 31 March 2019
|MSCI World Index*||
|Denker Global Financial Fund**||
Source: *Bloomberg (index and Berkshire); **Morningstar and Denker (Global financial Fund); %’s are net of fees and costs and with dividends re-invested. For the 16 year fund return we assumed an annual charge of 1.85%
The power of compounding
At the age of 11 Buffett first understood the power of compounding. He says, ‘after that I was afraid to spend 50c on ice cream, each time thinking this is a future $500 I’m spending’. But once he understood this, two things followed:
- Compounding needs time. That’s why a moat is necessary: you want to be sure the company you invest in can generate high returns for many, many years. (The alternative is to get onto the treadmill of cigar-butt investing.)
- A higher rate of compounding makes a huge difference over time – Table 3 below explains this well.
Table 3: The power of compounding at work
One initial investment of R100,000
Source: Denker Capital
Predictable and sustainable returns matter
Buffett increasingly invested in businesses with high returns on equity that were sustainable but stayed away from so-called ‘challengers’. Why? Back to Aesop’s ‘a bird in the hand is worth two in the bush’. Challengers have the potential to outperform, but because they don’t have a track record, they carry high investment risk. Amazon didn’t generate a profit until recently and Buffett was only prepared to invest now that he has a high degree of certainty that Amazon has become unstoppable. But they still feel that swopping Walmart for Amazon 10 years ago would have been too risky. The birds in the bush weren’t worth the risk (in both Buffett’s and Munger’s eyes). Whether you agree with this or not, the principle is important: few investors understand the effect a capital loss has on a portfolio. Volatility is okay, but lost capital you never get back. The challenge is to increase returns without increasing the risk of capital loss.
Not how much risk, but which risks does one want to take?
Table 2 above shows that, for the 5 year period to 31 March 2019, the Denker Global Financial Fund returns were below Berkshire Hathaway’s. This was caused by currency weakness in emerging markets in 2015. This illustrates a few points:
- In our Global Financial Fund, we have found that over the longer term we can generate higher returns for investors by investing a portion of the fund in smaller companies as well as banks in selected emerging markets.
- BUT: This does increase volatility, as the five-year returns demonstrate.
- However, over time these positions have added significant value for investors who remained invested.
- This is a problem we face in our industry that Buffett doesn’t have. Investors can sell Berkshire Hathaway shares (and many have done so in times of turmoil to their later regret), but this doesn’t affect the funds he manages (ie he doesn’t have inflows or outflows). This enables him to think and invest for the longer term.
- Buffett’s top 10 represents 80% of his listed portfolio. In our case, that is 46%. I would love to increase the concentration but have to weigh up the effect increased volatility will have on investors.
- Nevertheless, the returns of our top 10 (see Table 4) does show one advantage we have over Buffett. We are small enough to be able to invest in companies that are old enough to have a reliable track record, but young enough to achieve a higher rate of shareholder value growth.
Table 4: The top 5 holdings of the Denker Global Financial Fund versus Berkshire Hathaway
|Denker Global Financial Fund top 5*||1 year||2 years||3 years|
|Tinkoff Credit Services||2%||20%%||501%|
|One Savings Bank||8%||7%||50%|
|Unweighted average return||10%||37%||181%|
|Berkshire Hathaway top 5*|
|Bank of America||4%||36%||121%|
|Unweighted average return||12%||30%||72%|
|*We used the top five for 2018, which isn’t representative, but we had to do it this way because Apple wasn’t held for the full three years (as an example).
** Total returns for 12, 24 and 36 months to 30 April 2019
Source: Denker Capital
Concluding and most important thoughts about money and life
The objective of the shareholder meeting was, and still is, to enable shareholders to ask questions about the business and the most recent results. But as both Buffett and Munger feel a duty to pass on wisdom, it has become a bit of a wisdom-dispensing session as well.
Based on the above, there is a funny contradiction in the answers many received
Most of the 44 000 people that attend the shareholder meeting (or others that listen in) hope to get stock tips (‘What are Berkshire Hathaway’s top 5 non-US holdings?’) or investment insights (‘What must I do to become a successful investor like yourselves?’). They hope to get information that will help them grow their wealth. But the answers they received were:
- ‘Money does not equal happiness.’
- ‘If you don’t enjoy life as it is, having more money isn’t going to change that.’
Not quite the answer they had in mind. Nevertheless, coming from two wise men aged 88 and 95 it is noteworthy, and maybe that is why many people do go
Those who hoped to get ‘freebies’ got direct answers
‘We will explain principles (in order to help shareholders understand why we made the decisions we made), but we won’t give proprietary information other than that which we are forced to disclose by regulation.’
‘Berkshire Hathaway is not an investment advisory house . . . we can’t and don’t give investment advice.’
A team of one, rather than a committee-based approach
Many investors try to copy Buffett. Many try part-time DIY investing but forget to measure themselves through the cycle. And as he has often said: ‘managing your own portfolio based on the advice of others, or radio or TV shows, is like doing open heart surgery on your wife via Google’. The potential savings are just not worth the risk. Besides, very few have Buffett’s emotional strength (to ignore the crowd) or his insights.
But he has shown that you don’t need a team and you definitely don’t need a committee. I’ve got a great team – they complement my weaknesses and have strengths that I don’t have (a bit like Buffett and Munger). But teams that get too big can become debilitating, as you end up spending more time massaging egos, motivating the team, and devising incentive structures than discussing stocks. Relationships like that of Buffett and Munger are fairly unique.
Buffett and Munger have truly delivered astonishing returns over 52 years since Buffett gained control of Berkshire Hathaway. It’s well worth reflecting on what made them so successful. Few do.
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