As with most things the prerequisite to getting the right answers is to first ask the right questions.
Before a portfolio can be constructed or a specific investment made, foundation questions must be addressed.
What level of volatility is an investor prepared to tolerate?
Over what time scale are they prepared to invest?
What returns are they seeking to achieve?
What is their level of knowledge?
Are expectations of outcomes realistically set?
It’s not meant to be easy!
Charlie Munger’s famous quote that investing is not meant to be easy is more profound than it sounds. To excel at any discipline has to be profoundly difficult otherwise everyone would do it and it would therefore have no value. In fact logically anyone who tries is battling basic maths, to consistently be above average is to be unusual, unless actions demonstrate unusual knowledge and skill, consistent success can’t and won’t occur.
Howard Marks wrote recently of a question he used to ask prospective employees.
“I will pay you $10 million a year but only if you are in the top 10% of market performers and nothing if you aren’t, what would you do?”
He said no one had answered correctly.
The logical reply is.
To invest in things virtually no one else invests in, that is the ONLY way I can be in the top 10% of performers. If I do what others are doing I will guarantee I’m average and I won’t get paid.
Several of the most successful investors including Seth Klarman, David Tepper and Howard Marks himself invest significantly in distressed debt. The reason being it’s a neglected area where general understanding is poor and so significant mispricing occurs.
They have used exceptional skill and care in identifying debt, which will yield multiples more in bankruptcy than believed and so have made tremendous returns.
Active or index?
There has been a number of articles recently about Warren Buffett and the performance of the Berkshire Hathaway (BK) share price over the last five years.
Mr Buffett’s legend has been built in part from the stellar performance of BK stock; it has increased by around 20% per annum since the early 70’s as an average (not consecutively).
Investors who have simply allowed the compounding effect of the growth to do its magic have seen moderate initial investments turn to life changing sums over that time.
In the last five years however BK shares have risen less than the S & P in four of them, there is now an increasingly noisy chorus that Warren has lost his mojo. It would have been better to have put money into an S & P tracker.
Asking the right questions
Using Berkshire as an example of why it is crucial to ask the correct questions before answers become useful and usable.
Berkshire is a collection of wholly owned companies and a portfolio of publicly traded shares.
So the first question is how did the quoted share portfolio do against the S & P over the last five years?
The answer is that it outperformed. So to compare Mr Buffett’s direct investments to the index is to illustrate he did beat it.
The second question is how diversified are the wholly owned businesses?
The answer is very, a large element is insurance, another large element is housing related and a third is utilities (including rail which is regulated not unlike a utility). This is important as the company is not playing in narrow channels where periods of excessive returns can distort performance, it is in fact geared to the well-being of the US economy as a whole which lessens volatility.
The third question is how has the metric of book value performed?
Book value measures the growing value of the owned assets, if this increases faster than the share price the value offered by shares as a fractional ownership becomes greater.
The book value of Berkshire is more nuanced than most companies and needs the additional understanding of intrinsic value to establish true worth. (See Geico below.)
Is BK a buy?
To answer this question is to go back to the title of this piece, what does an investor need to know?
Is the Berkshire share price likely to significantly outperform the S & P? NO
It’s now of a size that will cause it to track the index more than smaller companies.
Is it a collection of ‘best in breed’ businesses run by talented and motivated directors with an overarching culture of honesty, fairness and commitment to shareholders best interests? YES
Can this be said of the S & P as a whole? NO
Does BK carry the same volatility risk as the whole index and if not is it higher or lower?
The answer is lower, the company has a strong value bias to past purchases meaning it has not overpaid for the assets it owns, it also invests in areas which have long term futures and are not prone to creative destruction.
Insurance, Utilities, Housing and Railways will be around in 30 years’ time and prices will be higher. The biotech companies, cloud computing solutions, internet content providers, who knows?
Is there hidden value in the balance sheet? YES
As an example Geico is the second largest personal lines Insurance Company in the US. It is wholly owned by Berkshire having been bought in two chunks, the last 50% in 1994.
At that time the goodwill element of the purchase was calculated at 1.4 billion dollars (this is the difference essentially between the purchase price and the asset value) Mr Buffett calculates this value today to be around $20 billion, it will however always remain in the accounts at the initial amount.
So book values are shown at the purchase price in the balance sheet (GAAP Accounting rules) but the reality is that the value can now be multiples greater, which would be reflected if a publicly traded stock.
There are a large number of wholly owned companies within BK that this applies to which means INTRINSIC VALUES are underestimated in the accounts.
So as an investor I ask myself what I want from an investment.
Do I want equity exposure?
Yes, I do because over time equities are generally the best performing asset class.
Do I want high levels of volatility?
No, I accept that equity markets are more volatile than most other asset classes but I do not generally want to invest in stocks which have high price to earnings multiples because of future expectations of strong growth as this is speculative and impossible to predict.
So what do I want?
I want understandable companies with a predictable future of relevance built on strong enduring principles, top quality asset allocation skills and a valuation which under (not over) estimates future potential.
What are my timescales?
I know the more I buy and sell the more I surrender in costs and tax so logically I want to buy and hold unless there is a fundamental change of circumstances or the price significantly exceeds value.
Do I have the knowledge to make this investment?
I can be reasonably confident that Mr Buffett has the knowledge to buy at the right times, he has said he will buy back Berkshire stock if the price is at or below 1.2 times book value, I can therefore use this as my benchmark to act.
Do I mind that over periods the Berkshire share price under performs the S & P index? NO & YES
I don’t mind at all that the market allows me to buy a quality stock at low prices but I do mind if the underperformance is due to poor business execution or deteriorating prospects.
A skill of successful investing is to be able to quantify which one it is, to understand as much as possible about a company and then acting decisively on the occasions when the price asked significantly underestimates the potential and value received.
NOTE: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.