Listening to Warren Buffett, Charlie Munger and other smart investors over the course of the weekend surrounding the Berkshire Hathaway meeting in Omaha is always informative. This year was marked by the usually laconic Charlie Munger, known for his typical “I have nothing to add” answer, answering many questions in depth. Below I examine my 10 insights from this year’s trip, which are a combination of new ideas and helpful reminders about those from the past that are still important today.
- “One of Berkshire’s secrets is that when there is nothing to do Warren is very good at doing nothing.”[i] – Charlie Munger
Investors frequently discount tomorrow’s opportunities. The result is that when there is nothing to do that meets their investment criteria they frequently opt to invest in the best of what is available – adopting a relative rather than an absolute approach. As I have argued in The Low Cost of Inaction: Don’t Just Do Something, Stand There! adopting a relative approach and forcing yourself to invest can often be a mistake. One of Buffett’s key strengths is being exceptionally disciplined in waiting for investment opportunities that meet both his qualitative criteria and offer a substantial margin of safety by way of a large discount from intrinsic value. Doing otherwise has the potential both to result in mediocre long-term returns and to increase the risk of permanent capital loss.
- “I can't give you a formulaic approach to investing because I don't use one. I analyze all of the factors and come up with an intrinsic value. If you want formulas you should go back to grad school so that they can teach you things that don't work.”– Charlie Munger
Investing is part art and part science. Those just starting out frequently search, often in vain, for a clear-cut and rigid approach. They hope that if only they diligently apply a formula or a precise set of rules that their efforts will be successful. While one should have a rigorous process, analyzing a company’s qualitative attributes or the caliber of its management team can’t be reduced to a formula or a mechanical exercise. Nuanced judgment is required. The same holds true for other parts of the investment process, including deciding which companies to investigate and estimating the future profitability of the business under consideration. The old adage – that good investing is simple, but not easy – definitely holds true.
- “Competitive moats have always been under attack, but the pace of change has become faster than it had been in the past.” – Warren Buffett
A competitive advantage, or a “moat” as Buffett calls it, has never been permanent nor static. Competition catches up to many companies, technology evolves and consumer preferences shift – all of which can change a company’s competitive position from formidable to mediocre. On the other hand, a skilled management team can take actions which can improve a company’s competitive position, widening the moat. In the last decade the pace of change has accelerated in a number of industries, in part driven by the internet and the new business models that it has given rise to. One implication for a value investor is to be particularly vigilant against the danger of investing based on “yesterday’s moats.” Merely establishing that a company has a strong competitive advantage is insufficient to conclude that it will remain sustainable, and extra diligence is needed to understand if and how the moat might erode.
- “My theory is that if a business can't withstand a little mismanagement it's not a good business.”– Charlie Munger
Sometimes there is debate about whether it’s more important to have a high-quality business or competent and aligned management team that can adopt to change well. While ideally we would have both, it’s important that a business not be so fragile as to allow management missteps to permanently impair it. If the business truly has a sustainable competitive advantage, then it should be able to recover from temporary mis-management and regain its past position.
- “For some businesses the corporate tax cut benefits will get competed away and be passed on to the consumer, for others some or all will be retained by the shareholders.”– Warren Buffett
The naïve, “level 1”, analysis is that as the corporate tax declines, corporate profits will increase commensurately. However consider two companies with no advantages in a commodity industry that were previously just earning their cost of capital. If the above analysis were to hold true, all of a sudden these two companies would start earning abnormal returns above their cost of capital – not a likely result given the nature of the industry and their competitive position. If that were the natural long-term equilibrium for their situation, they would have been already earning returns in excess of their cost of capital prior to the tax cut. So the stronger the company’s competitive advantage and pricing power, the more likely it is to keep the benefits of the tax cut.
- “Markets grow more efficient as they get older.”– Warren Buffett
Security markets in mature countries like the US have likely become more efficient over time. This makes sense – participants have had time to understand the companies and have a robust historical data set on how they get priced over time. This however does not imply that markets have become efficient and that there is no opportunity for a thoughtful value investor following a rigorous process to occasionally find undervalued securities. Recall that the two main reasons for market inefficiency are behavioral biases and perverse incentives of some of the participants. These factors are not likely to materially change any time soon as they are deeply structural in nature.
- “If you are going to live a long time, you have to keep learning. You have to keep revising your previous conclusions.”– Charlie Munger
The hardest, and yet the most important, thing in investing is the balance between conviction and flexibility. Knowing which one is appropriate at any given time is one of the main qualities that best investors possess that sets them apart from the rest. You have to continue to learn and evolve as an investor – something that we have observed Buffett do extremely well over his career. However, there is a difference between evolution from first principles and allowing a particular market environment or situation to disproportionately affect your approach.
For example, in the current environment in which there are few bargains, a number of value investors have decided to “evolve” into a more qualitative, less price-sensitive approach. Their argument is that if they can find great businesses managed by great management teams with a long runway for growth, that price is of such secondary importance that one shouldn’t worry too much about valuation. Many of them are likely to discover that they are wrong. A very small handful of investors are such good business analysts and estimators of the future that they can consistently buy stocks with very high embedded expectations and still do well. Yet a far larger group fancies themselves to be able to accomplish this very difficult task. Those who are over-optimistic about their abilities are likely to come to regret that they allowed the market environment to disproportionately impact their investment process.
- “We don't foresee things that we don't have a lot of evidence for.” – Warren Buffett / “If we were assessing Coca Cola right after it was invented, we wouldn't have invested.”– Charlie Munger
Buffett said that what Jeff Bezos accomplished at Amazon is a miracle – and that is precisely why they didn’t invest in the company. When something is extremely unlikely and there is no historical evidence to support the belief that it’s going to succeed, it is very difficult to correctly anticipate the outcome. There are certainly those, such as some early-stage venture capitalists, who are really skilled at this type of approach. For the rest of us having substantial evidence of success to aid us in our analysis of what the future will look like is likely to improve our chances of successfully choosing the right investments.
- “We don't know where interest rates are going, and the good news is that neither does anyone else, including members of the Federal Reserve. We do know that the long bonds are currently a terrible investment.” – Warren Buffett
One of my competitive advantages as an investor is that I exclusively focus on investment situations where it is the microeconomics that are going to dominate the outcome. I want to be able to bring to bear my substantial experience in analyzing companies and industries rather than to allow macroeconomic factors to determine the outcome. Many like to opine about the future direction of the economy or interests rates, and yet consistent success at this endeavor has proven elusive over time. I know that these are not things that I know much about, and I choose investment opportunities accordingly.
- “When you buy something where you are hoping that tomorrow it will be priced higher, you are counting on more people continuing to buy it, and eventually it comes to a bad end. Generally, when buying non-productive assets like cryptocurrencies, you are counting on someone else to buy it for more. It has been tried with tulips and other things in history and usually it has ended badly. If you bought gold in the time of Christ and calculate its compounded annual return until now, it is less than 1%.” – Warren Buffett
The intrinsic value approach relies on estimating value based on a combination of the net present value of the future cash flow stream of a business and any excess assets not used to generate those cash flows. The dean of value investing and Buffett’s teacher, Benjamin Graham, has famously said: “In the short-term the market is a voting machine, but in the long-term it is a weighing machine.” Assets that don’t produce any cash flows and cannot do so in the future are by their very nature speculative – there is nothing to “weigh”. The only reason that their price will go up or down is the opinion of other market participants. There is no way that I know of to estimate their intrinsic value, and therefore whether they be tulips, gold, crypto-“currency” or other things that have not yet been imagined, but which derive their worth solely from the opinion of others, I plan to stay far away from them as they fall outside of my circle of competence.
[i] All quotes in this article are based on my notes and my memory. While I made every effort to be accurate, it is possible that there may be errors, omissions or inaccuracies despite my best efforts to avoid them.
Article by Gary Mishuris, Behavioral Value Investor