I spent some time traveling in the car last week. Whenever I am driving by myself, I always listen to something—usually related to business or investing. I keep a long list of videos of interviews or talks that I can pick from whenever I am in the car. On this particular short trip, I had got through two different videos. I listened to this talk from 2012 where Jeff Bezos talks about Amazon Web Services—the cloud computing services business that Amazon has built into a juggernaut. It’s a pretty good talk that outlines much of how Bezos thinks about not just AWS, but his retail business in general.
The second video was a talk that Buffett gave to a group of students at the University of Florida back in 1998. I've listened to this video numerous times over the years, but it is one that I have on my favorites list and is worth listening to every year or two.
After Omaha last week, I heard someone say that Buffett and Munger “never say anything new”. This comment was probably out of frustration that Buffett and Munger didn't unveil some secret formula for success in investing.
The fact that these guys have been so successful by sticking to the same gameplan—in terms of general investment principles—should actually be a lesson in itself. Never wavering on their basic philosophy has brought them a long way. Tactics have changed over time as they've grown, but the concepts they implemented very early on have remained the same.
The University of Florida talk from 1998 is one of the best when it comes to articulating very clearly these investment principles that have served Buffett and Munger so well for so long. There is nothing “new”, but sometimes just going back to the basics is beneficial.
Here are some highlights from the talk (along with the time in the video of the comments):
On the Economics of Good Businesses (11 minute mark)
In response to a question about Japan, Buffett mentions how most Japanese businesses produce low returns on equity, and how time works against you when you own low return businesses:
“Japanese companies earn very low returns on equity. They have a bunch of businesses that earn 4%, 5%, or 6% returns on equity. It's very hard to earn a lot as an investor when the business you're in doesn't earn very much money.”
Buffett goes on to explain that some people can invest profitably in such businesses, and he talks about how he used this method in the early years. He also references Walter Schloss, who made a career out of owning such businesses. Schloss would buy low earning (or sometimes money-losing) businesses that were trading below the value of the net tangible assets the company owned. It's an approach that can work well, but I've found that it's an uncomfortable way to invest—it often means owning bad businesses, and I prefer avoiding bad businesses. I've found that when I've owned bad businesses because I was attracted to the valuation, I become much more influenced and concerned with the behavior of the stock price, or even the general economy. Many bad businesses trade cheaply, but won't survive the next recession. Glenn Greenberg once said that he wanted his portfolio filled with stocks that he would feel comfortable owning if a 1987-style stock market crash occurred (when the market plummeted over 20% in one day). I won't comment on his largest current position or any other stocks in his portfolio, but I do think there is a lot of merit in that concept. If you own good businesses with strong earning power, you're less concerned (or hopefully not concerned at all) about the stock market or the near term prospects for the economy.
The other problem with a Schloss-type approach is it requires a plethora of ideas that have to be continually replaced. Because the businesses are of low quality in some cases, you need plenty of diversification. Also, since you have to sell these stocks as soon as the price gets a modest bump, you need to be constantly looking for the next idea.
I think Schloss' asset-based approach worked well in part because the US economy was much more manufacturing-oriented in the 1950's, 60's and 70's. Manufacturing was responsible for just 12% of US GDP in 2015, down from 24% in 1970. Service producing businesses have taken share from goods producing businesses, and now make up a much greater piece of the overall economic pie, and these service businesses tend to operate with much lower amounts of tangible capital. Trying to find service businesses trading below book value is a mostly irrelevant and futile exercise—the ones that do tend to be going out of business, and rarely do these make attractive investments.
But the concept of buying cheap “cigar butt” stocks vs buying good businesses is a debate that still goes on, and both approaches can work, but the tactics involved are very different.
As I've talked about before, I think Buffett grasped the power of owning good businesses at a much earlier age than many people realize.
Buffett caps off this question by saying:
“If you're in a lousy business for a long time, you're going to get a lousy result even if you buy it cheap.”
Long-Term Capital Management (13 minute mark)
Buffett talks about the background of LTCM, which is a fascinating story in general. One of my favorite books on the topic is When Genius Failed by Roger Lowenstein. This book is a must read for all investors in my opinion.
He uses the story as a teaching moment, and discusses the dangers in leverage, overconfidence, and numerous other biases/mistakes that were made by incredibly smart people.
The takeaway here is that formulas and mathematics only take you so far. You need to apply logic and reason to risk management, not just computer-driven models:
“Those guys would tell me back when I was at Solomon that a six-sigma event wouldn't touch us. But they were wrong. History does not tell you the probabilities of future financial things happening.”
How do you decide how much to pay for a business? (32 minute mark)
This is an interesting question because Buffett—despite producing incredible returns in his partnership and the early Berkshire years—says he was never trying to go for home-run type returns. He was more focused on finding the sure bets—investments where he was fairly certain to make money without taking much risk:
“I don't want to buy into any business that I'm not terribly sure of. So if I'm terribly sure of it, it probably isn't going to offer incredible returns. Why should something that is essentially a cinch to do well offer you 40% a year or something like that? So we don't have huge returns in mind. But we do have in mind never losing anything.”
He uses Sees Candy as a case study for how he thinks about what to pay for a business. They bought Sees in 1972 for $25 million. It was selling 16 million pounds of candy at $1.95 per pound, and making $4 million pretax. He said that he and Munger basically had to decide if there was some untapped pricing power. If they could sell candy at $2.25 a pound, then $0.30 per pound on 16 million pounds was another $4.8 million of pretax profit on the same volume, more than double the current earning power of the business. Even raising prices by a nickel would produce a 20% gain in pretax earnings.
What I find interesting is that the purchase price itself was quite cheap—just 6 times pretax earnings, the equivalent of an after-tax P/E of about 10. But Buffett never even mentions the valuation in answering the question—almost as if it was an afterthought. He talked about the pricing power, references the return on capital (in this case Sees basically needed no capital), and talked about the attractiveness of the product. In the end, the decision to buy the business was made not based on whether the “multiple” was cheap enough, but because he and Munger decided the product had plenty of untapped pricing power—in other words, the product itself was very undervalued from the customer's point of view. They surmised they could raise prices and still maintain or grow volumes.
Buffett and Munger were correct in their view that the product was undervalued, and through pricing power and unit growth, Sees has produced over $1.9 billion in pretax profits to Berkshire from an incremental investment of just $40 million and a purchase price of $25 million.
Sees is an extreme example to be sure, but one that exemplifies why it's more important to be right on the business than right on the exact price to pay.
Qualitative vs. Quantitative (39 minute mark)
“The best buys have been when the numbers almost tell you not to.”
On Thinking Long-Term (45 minute mark)
“Coke went public in 1919. Stock sold for $40 per share. One year later it's selling for $19—down 50% in one year. Now you might think that's some kind of disaster, and you might think that sugar prices increased or the bottlers were rebellious… you could always find a few reasons why that wasn't the ideal moment to buy it. Years later you would have seen the great depression, World War II, sugar rationing, thermonuclear weapons… there is always a reason. But in the end, if you would have bought one share for $40 and reinvested dividends, it would be worth about $5 million now.”
Coke is obviously another rare example of a business that has survived and prospered for many decades, but Buffett's main point is the thing to focus on:
“If you're right about the business, you'll make a lot of money.”
Focusing on the “what” is more important than focusing on the “when”.
On Mistakes (49 minute mark)
Berkshire Hathaway itself is a mistake he often talks about (when it was a cigar-butt business that consumed a lot of cash and never really made any money).
He also brings up an interesting point: buying attractive securities of a business that he didn't really like. He mentions two examples: buying preferred stock in both Solomon and US Air. In both situations, Buffett ended up okay, but he came very close to losing a significant amount of his principal in both of these investments. He sums up the lesson:
“We bought an attractive security in a business I wouldn't have bought the equity in. You could say that's one form of mistake—buying something when you like the terms but you don't like the business that well.”
I think this could be extended to buying stocks when you like the terms (i.e. the valuation) but not necessarily the business.
Macro (54 minute mark)
“I don't think about the macro stuff. What you really want to do in investments is figure out what's important and knowable.”
He says macroeconomics (interest rates, economic trends, etc…) are important, but unpredictable.
He mentions what a mistake it would have been to not buy Sees Candy for $25 million (a business that was producing $60 million pretax in 1998 at the time of this lecture) because of some fear of interest rates or the near term economy (the US did in fact enter a significant recession and bear market in 1973-1974).
General Portfolio Management (60 minute mark)
“We never buy a stock with a price target in mind. We never buy something at 30 and say ‘if it goes to 40 we'll sell it.'… That's just not the right way to look at a business.”
Buffett obviously does buy and sell stocks—and did much more of that in his early years—but the concept is to focus on stocks not as trading vehicles with price targets, but as businesses that produce cash flow for owners. Mr. Market will always be there offering prices that can be taken advantage of, but the mindset should be firmly focused on the fundamentals of the business and its future earning power, not on where the stock will go or when it will get there.
Diversification (66 minute mark)
Buffett says that for most individuals, owning an index fund is the appropriate investment for stocks. But for those who desire to treat investing as a business and have an ability to analyze companies, diversification is a mistake:
“If you really know businesses, you probably shouldn't own more than 6 of them. If you can identify six wonderful businesses, that is all the diversification you need and you're going to make a lot of money, and I will guarantee you that going into a seventh one rather than putting more money in your first one is a terrible mistake.”
This is interesting because Berkshire obviously owns more than 6 businesses, but it's probably more useful to look back at how Buffett ran money when he had small sums. His personal account was very concentrated (he did 50% returns by owning just a few stocks at a time in the 1950's), and his partnership—according to the details laid out in Snowball—often had 3 or 4 stocks representing over half the portfolio—sometimes his best idea represented 25-40% of capital.
To Sum It Up
There are other valuable passages that I didn't highlight, but the entire video is worth spending 90 minutes to watch. There is nothing new in it, just as the shareholder meeting this past weekend had nothing “new”, but sometimes it's worth listening to the best investor in the world articulate his own philosophy in his own words—even if that philosophy is already seared into your mind.