Saturday, February 28, 2009

Learn From The Best

I've always believed that you should always learn from the best teachers, and that goes from physics to the martial arts. In the investment business Warren Buffett and Charlie Munger have always been in my personal pantheon of great teachers and practitioners. Their 2008 Annual Report was published today, and it is, as usual , full of study material, quotable quotes, refreshing candor and introspection. I'm going to reflect on a particular issue in an upcoming newsletter, but here are some notable points from a first reading.

Buffett, a world-class poker player, acknowledges that in the current credit crisis, the Fed and Treasury are "all in." Our own limited perspective gives us considerable heartburn, although Buffett does talk about having to take an aspirin. However, his overarching conclusion is that "America's best days lie ahead." I retain this point as a take-away. The financial websites seize on the comment that the economy is in a shambles and may stay that way. However, reading the letter closely and thinking about financial theory, Buffett concludes that neither he nor Charlie Munger can forecast the performance of financial markets during the same period. If indeed they lead at economic turning points, they may very well outstrip the shambolic economic performance. Who knows? I take comfort in the comment, because it's based on an economic and financial mindset, and not on wishful thinking. I'm happy for my children.

Buffett talks about the first principles underlying their management of Berkshire Hathaway. This should be obvious from a history of reading the letters, but human short-term memory makes a restatement useful. Whatever the economic backdrop and stage of the cycle, they strive to:
  1. Maintain a "Gibraltar like" financial position, meaning excess liquidity, modest short-term obligations, and lots of sources of earnings and cash;
  2. Widen the economic moats of existing businesses in the portfolio;
  3. Acquire and develop new earnings streams;
  4. Nurture and expand their stable of business managers who have led to the substantial value creation within Berkshire Hathaway.

If you own a position in a public company, take this list and ask yourself, "Is this what my executive leadership team is doing?" Now, there will have to be some adjustments to a literal interpretation, but if there is a wide divergence, you probably don't have a long-term investment on your hands, but a trade at best.

On the last point, this is something that is almost completely missing from the leadership philosophy of most public companies. Despite the windy rhetoric, apart from the CEO, most members of the leadership team at public companies are considered to be interchangeable cogs. The same philosophy holds for the senior staff of the executive leaders. The Berkshire letters are always rife with genuine praise for the integrity, philosophy, and business acumen of the leaders of their portfolio companies from Sees Candies up to the biggest insurance and utilities businesses. This is, in my opinion, a very important factor in decomposing their performance advantage over the S&P 500.

If you're approached by a brilliant financial engineering mind with a model that supports buying a securitized or structured product, think about this quote: "Beware of geeks bearing formulas."

On a set of related points, Buffett opines that improved transparency will not cure the problems that derivatives pose. He is not aware of any reporting mechanism that can effectively describe or measure risk from derivatives. Remember who's saying this. Insurance and re-insurance are their core business. His stable of managers in this business includes Ajit Jain and others whom he sees as among the most brilliant minds. Yet, he makes this comment. Furthermore, he correctly states that, "auditors cannot audit these contracts." So, we can't rely on their puerile efforts.

Then think about the fact that a lot of legislative and regulatory energy will be devoted to enacting measures around the clarion cry of transparency. So, our teacher is telling us that there will be no measurable benefit to the buy side of the market from all this make work.

Although Buffett has too much knowledge to try and forecast the market, he makes this substantive comment, "The investment world has gone from underpricing risk to overpricing it." He opines that looking back on this period, writers will talk of a bubble in Treasury securities, and this certainly seems to be the case.

For portfolio re-allocators, he offers this bromide, "Beware the investment activity that produces applause; the great moves are usually greeted by yawns." "Cash is king" is on the tongues of all the television talking heads, to lots of applause. High quality corporates and municipal bonds have been the yawning-inducing strategies pursued by some institutional investors. Interesting stuff as always.

Finally, we know that on Wall Street no one is responsible for the current, near-death crisis. No one has admitted to any errors of omission or commission. Yet Warren Buffet does so in his 2008 letter. Berkshire invested $7 billion in the common equity of ConocoPhillips a the peak of oil prices; as of the measurement date, the investment is worth $4.3 billion. Buffett laments his timing, although he believes that the fundamentals point to higher oil prices than current levels of $40-50 per barrel. I'm sure that he's right about oil for a variety of reasons. This candor and self-reflection is refreshing. But, using his own philosophy that no one can time a market, this hardly seems like a big deal. For someone who holds himself to a high standard, though, it's irritating.

Lots of good education for a Saturday.

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