Here is the final installment of the Buffett notes stocks series,
- Listen to Charlie Munger
Learning from Buffett’s letter is incomplete if we didn’t listen to his business partner and best friend Charlie Munger. After all, without any doubt, it was Munger who was responsible for moving Buffett toward focusing on business quality than just cheap price. From the start, Munger had a keen appreciation of the value of a better business, and the wisdom of paying a reasonable price for it. Through their years together, he has continued to preach the wisdom of paying up for a good business. In one important respect, however, Munger is also the present-day echo of Ben Graham. Graham had taught Buffett the twofold significance of emotion in investing – the mistakes it triggers for those who base irrational decisions on it, and the opportunities it thus creates for those who can avoid falling into the same traps. Munger, through his readings in psychology, has continued to develop that theme. He calls it the “psychology of misjudgement”. Here is more praise Buffett has showered, and deservedly so, on Munger in his 2014 letter…
Charlie has a wide-ranging brilliance, a prodigious memory, and some firm opinions. I’m not exactly wishy-washy myself, and we sometimes don’t agree. In 56 years, however, we’ve never had an argument. When we differ, Charlie usually ends the conversation by saying: “Warren, think it over and you’ll agree with me because you’re smart and I’m right.” What most of you do not know about Charlie is that architecture is among his passions. Though he began his career as a practicing lawyer (with his time billed at $15 per hour), Charlie made his first real money in his 30s by designing and building five apartment projects near Los Angeles. Concurrently, he designed the house that he lives in today – some 55 years later. (Like me, Charlie can’t be budged if he is happy in his surroundings.) In recent years, Charlie has designed large dorm complexes at Stanford and the University of Michigan and today, at age 91, is working on another major project. From my perspective, though, Charlie’s most important architectural feat was the design of today’s Berkshire. The blueprint he gave me was simple: Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices.
- Beware of Companies Making Acquisitions Would you risk your life savings on a coin toss? Of course you wouldn’t. But over the past few years, CEOs of many Indian companies – large, mid, or small – have risked their business with the same odds – by making disastrous acquisitions. They have shown what thrill for action when combined with cheap money can destroy shareholder wealth in such huge scales. Acquisitions are often misused as the universal, over-simple growth formula, or just as a quick fix. As buying companies also boosts egos of managers making acquisitions, the essential questions can end up being dismissed as irrelevant, boring, or too mundane to be answered properly. This is exactly what Buffett captures when he writes about companies making expensive acquisitions and investment bankers justifying the same. Too often CEOs seem blind to an elementary reality: The intrinsic value of the shares you give in an acquisition must not be greater than the intrinsic value of the business you receive. I’ve yet to see an investment banker quantify this all-important math when he is presenting a stock-for-stock deal to the board of a potential acquirer. Instead, the banker’s focus will be on describing “customary” premiums-to-market-price that are currently being paid for acquisitions – an absolutely asinine way to evaluate theattractiveness of an acquisition – or whether the deal will increase the acquirer’s earnings-per-share (which in itself should be far from determinative). In striving to achieve the desired per-share number, a panting CEO and his “helpers” will often conjure up fanciful “synergies.” (As a director of 19 companies over the years, I’ve never heard “dis-synergies” mentioned, though I’ve witnessed plenty of these once deals have closed.) Post mortems of acquisitions, in which reality is honestly compared to the original projections, are rare in American boardrooms. They should instead be standard practice. 13. Wait for Fat Pitches Given that stocks go up and down, the best way to win at the investing game is to have the discipline to form your own opinions and the right temperament, which is more important than IQ. All you have to do is sit there and wait until something is really attractive that you understand. But by listening to everybody talk on television, especially because everybody sounds authoritative, investors often turn this fundamental advantage into a disadvantage. There’s no easier game than stocks, if and only if you don’t play it too often. And you play only when you get the fat pitches inside your circle of competence.
Here is what Buffett writes on the need to avoid listening to financial experts, and especially when the tide is rising and everyone is rising with it… Periodically, financial markets will become divorced from reality – you can count on that. More Jimmy Lings will appear (Lings was a 1960s-era US businessman who founded the company LTV, and invented what he called “redeployment.” During an era when most companies made products and sold them, he saw the future of business: acquisitions and mergers). They will look and sound authoritative. The press will hang on their every word. Bankers will fight for their business. What they are saying will recently have “worked.” Their early followers will be feeling very clever. Our suggestion: Whatever their line, 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.
- Cash is King One of the characteristics that define a great business is its ability to constantly generate more cash than it consumes. Cash is after the life-blood of a business, and the biggest wealth creators in history have been companies that have managed this assed well. Buffett has always stressed on the importance of cash, and here is what he reiterates in his 2014 letter… Financial staying power requires a company to maintain three strengths under all circumstances: (1) a large and reliable stream of earnings; (2) massive liquid assets and (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 mindset can be. 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. American business provided a case study of that in 2008. In September of that year, many longprosperous companies suddenly wondered whether their checks would bounce in the days ahead. Overnight, their financial oxygen disappeared. 15. Respect Alternative Histories One peculiar but common way our brain works is that we often remember what’s easily available to us, and see what’s easily visible. So, we conclude that the stock trader who is rich must know what he is doing. In the same way, an investor who uses leverage to increase his bets and in the process magnifies his returns is also considered a role model. In business, a CEO who borrows a lot of money to make acquisitions and in process turns his business bigger in quick time, also seem to be doing the right things (at least when times are euphoric). In effect, the general belief is that if the outcome is good, the process and decisions made to arrive at that outcome must have been sound. Right?
Well, I hope if life were that easy and followed such straight patterns. But that’s not the case especially when randomness and ‘external factors’ play a role and in investing they do play a significant role. At least, if you were to believe what Nassim Taleb has to say about “alternative history” in his amazing book “Fooled by Randomness” – “Imagine you are offered $10 million to play Russian roulette, i.e., to put a revolver containing one bullet in the six available chambers to your head and pull the trigger. Each realisation would count as one history, for a total of six possible histories of equal probabilities. Five out of these six histories would lead to enrichment; one would lead to a statistic, that is, an obituary with an embarrassing (but certainly original) cause of death.” This thought is echoed by Buffett in his letter when he writes about CEOs taking undue risks to grow their businesses… A CEO who is 64 and plans to retire at 65 may have his own special calculus in evaluating risks that have only a tiny chance of happening in a given year. He may, in fact, be “right” 99% of the time. Those odds, however, hold no appeal for us. We will never play financial Russian roulette with the funds you’ve entrusted to us, even if the metaphorical gun has 100 chambers and only one bullet. In our view, it is madness to risk losing what you need in pursuing what you simply desire.