Saturday, February 28, 2015

On 2014 Berkshire Special Letter: Buffett's Confessions and Lessons

Berkshire released its annual chairman letter to investors today. This edition is a special 50th anniversary edition that included two special sections. These two sections are commentary written by Bufffet and his partner Charlie Munger on Berkshire's past, present and future. The letter overall is a great read and I highly suggest everyone to read it.

Below are some of my own commentary on the key points in Buffett's section, which included several lessons he learned and the lessons he wanted readers to comprehend. I will write a separate post for Munger's section. 

Lesson #1: Don't focus on eighth or a quarter of a point
Buffett is a better storyteller than me so I won't go into all the details but he got himself into a lot of trouble when he decided to put more money in a sinking ship (Berkshire) because he was offered 1/8 ($11.375 instead of $11.50) for the shares he owned in a tender offer. Angry over 1/8th of a dollar, he bought more shares (more than doubled his initial position) and went on to sack the CEO and tried to "turnaround" the company by appointing new management. Buffett found out that the extra money he plowed into Berkshire was hardly earning anything. It would be a miracle just to avoid losing money. All this trouble was due to a temporary anger over 1/8th of a dollar. If he had sold his shares, which he bought for $7.50, at $11.375, then he could have used the proceeds to invest in other assets and the money would have grown into vast sums given the law of compounding and his investment record of achieving returns of 20% per annum  (doubling every 3.5 years). 

What's the lesson here for investors? Never focus on the tiny quarter of a point. If you want to purchase stock X because it looks very attractive, it's tempting to wait until the stock drops before buying. However, if you feel stock X is worth $20 and the stock is $10, why wait till it drops $0.25 or $1? Paying attention to these small amounts can cause you to miss large gains. The point is also valid when considering selling positions. Overall, step back and you'll realize that some of these small things never really matter. 

Lesson #2: Don't mix good business with bad ones 

"When you mix raisins with turds, they are still turds" Charlie Munger

The best decision in the early days of Berkshire was Buffett's decision to buy National Indemnity (NICO). This was the first step into Berkshire's success by entering the lucrative insurance business, which provides interest-free cash up-front that can be used to invest. This was one of Berkshire's secret sauces. Use interest-free float to generate more money through investments than the potential future claims cost. 

If the purchase of NICO was a right decision, why did Buffett admit it was a mistake? His mistake was not regarding the acquisition but how he structured the acquisition. He merged NICO with Berkshire, allowing Berkshire's legacy shareholders to own 39% of the combined entity. By trapping lucrative cash flows in Berkshire's junky textile manufacturing business, growth of the combined entity was limited by the large bleeding within Berkshire's legacy business. The opportunity cost of this drag was estimated at $100 billion (with a B) by Buffett. Although he eventually closed Berkshire's textile business in 1985 (20 years too late by the way), the funds that were sunk into the textile business would have generated significant cash over time, through compounding, if he had just the nerve to close the business when he gained control. 

What's the lesson here for investors? Investors should avoid even the most wonderful businesses if they make terrible acquisitions by buying terrible businesses with low returns and suck cash out of the parent (requiring high re-investment with no free cash flow generating potential). Forget the "synergy" pitch (a.k.a. 2+2 = 5)  or the "cost savings" pitch (a.k.a. firing workers) management give investors when doing an acquisition, investors should always focus on the cash generating potential of the acquired asset. Although the monetary costs in present dollars may be small, the opportunity costs of mixing good businesses with bad ones can be huge in future dollars, especially because the funds used to buy the poor businesses could have been invested in other productive assets that compound over time. Buffett admitted that the attractive purchase of Waumbec Mills (another texile company) in 1975 fits this bill perfectly and added to his initial Berkshire mistake. 

Lesson #3: A good business can be wonderful
Buffett has mentioned plenty of times that his partner Charlie Munger has turned him into a better investor by buying "wonderful businesses at a fair price." The change took a while but was needed. As he admits in this letter, a cigarbutt approach (buying cheap businesses and selling them when they start to recovery) was fine for small amounts of capital but for larger sum of capital, a "good business" approach was needed. It's also something I think most fund managers need to understand. Their niche strategies - whether it is arbitrage, net-net, or spin-offs/corporate restructuring - may work well with small amount of AUM but cannot work at a high AUM figure. To perform successfully, buying good businesses with stable earnings, low leverage, and growing free cash flow is needed.  

Buffett always used See's candy as the example and I did too in a prior post. He reported that since Berkshire (or the predecessor Blue Chip Stamps) purchased See's in 1972, the business has earned $1.9 billion (or $1.25 billion assuming a 35% tax rate). That number is significantly bigger than the incremental $40 million that was plowed back into the business during the same time period. But wait, that's not all. These funds was re-invested in other assets so the overall future value of those cash flows are worth much higher than the sum of the cash flows received.

An investor who is investing in these kind of businesses would see exponentially higher dividends (more cash to re-invest with) or share repurchases (increase ownership and hence the claims of that company's future free cash flow) which enhances the value of their holdings. 

Lesson For the Reader: How to evaluate M&A and the dark side of M&A
To build on the lesson discussed above, buying bad businesses and mixing them with good businesses is especially dangerous when management use their own "stock" as currency. It doesn't make sense trading one $100 bill for four $20 bills. Yet management of corporations do that all the time because they focus on trading for the number, not the value, of the bills. The number in question is the "earnings per share" (EPS) that sell-side analysts and fund managers care about. Management even created a fancy term to justify their actions called "EPS accretion". 

Even Buffett himself was not error-free in this case. He bought a company called "Dexter Shoes" with Berkshire stock in the 1990s. That mistake was extremely costly because it diluted the shareholders and received essentially nothing for that pain. 

Furthermore, don't forget that management may become extremely sensitive to short term factors and become servants of the capital markets instead of the shareholders. Capital market participants, whether be the investment bankers or the corporate raiders (ahem...I mean activist investors), want a share of corporations' success by "encouraging" them to consider "strategic alternatives".  As Buffett outlines in the letter, there is so much indirect frictional costs that shareholders never benefit fully from the success of the companies they own. It is surprising how companies pay 20-50% premium for business T and then spin it off later as business S. Companies like Kraft, which was bought by Philip Morris and then spun out (first as Kraft and then it was separated again into two more pieces), is a good example of the pattern Buffett described. Another example is BHP Billiton. The 2001 purchase of Billiton was completely reversed after its recent announcement to spin them off as South32. 

The "helpers" - the bankers, consultants, lawyers - who propose the strategic alternatives will probably make more money than the shareholders in the company that undergoes such process. Companies should focus on the long term instead of considering all those strategic alternatives when the helpers come knocking at their doors.  

It is fine to use acquisitions as vehicles for future growth but it has to be part of a long term strategy. In fact, many businesses will have to use M&A as a viable future growth path. Therefore, investors should evaluate the acquisitions decisions of the companies they own. Do they make sense in terms of strategy, culture (this one is commonly forgotten) and of course the price. The price is essential because you don't want to pay more than what you receive. The evaluation on the price is hard especially for stock transactions that require an intrinsic value estimate for the buyer as well as the seller. Thus, dig deeper than common first level details such as "synergies", "cost savings", "EPS accretion", or "revenue growth".   

Lesson For the Reader: Capital Allocation and conglomerate
Buffett has gave a great lesson on conglomerates in this letter. On the surface, the structure is hardly efficient at all but there is a method to utilize its advantage. It is something that not many managers understand: capital allocation. 

Good capital allocation practices use free cash flows generated from stable businesses and re-invest them back into the most profitable opportunities. It's not rocket science: use free funds, that are generated from existing businesses,  to invest in companies/subsidiaries that can generate the highest returns. The glue that sticks the subsidiaries together at a conglomerate is the culture. Berkshire's culture is unique because every subsidiary is an independently-run business with no interference from head office in Omaha. Buffett has given his managers the mandate to manage their own businesses with the independence they need and shield them from the short-termism of the capital markets. He often tells his managers that the businesses they run is not for sale and its the only asset they have. With that kind of mindset and culture for achieving long term success, it's no surprise that Berkshire flourished. The success snowballs because Buffett wrote in this letter that Berkshire has become home to many wonderful businesses that would rather be owned under Berkshire than under an owner such as a private equity firm. Thus, with many good businesses to re-invest in and the large amounts of float generated by its insurance subsidiaries, Berkshire has the ingredients it needs to be successful. 

The lessons for investor here is good capital allocation and a strong culture is critical for any company. Berkshire won't have succeeded if it did not shut (although it was late) the cash bleeding textile businesses and re-allocated capital away from bad businesses. Moreover, Berkshire won't have succeeded if it did not have a cohesive culture that focused on the long term and ignored the noise from the short-term oriented capital markets. Investors want to invest in companies that can allocate capital efficiently and have a strong long term oriented culture. 

Lesson For the Reader: Preparing for the Future 
In his outlook for the next 50 years, Buffett said he is confident that the business he built is strong enough to outlive him and succeed. For more on this topic, please see Lawrence Cunningham's new book called "Berkshire Beyond Buffett: the Enduring Value of Values ."

One interesting point I want to direct readers is his point on cash. In many companies and even investment funds, managers want to minimize cash because it is an un-productive asset yielding near 0% or even negative percent in case of European cash equivalence. On the contrary, Buffett argues that cash is the best asset especially as insurance to protect the unknowable future. I fully agree with him. There is nothing wrong with a portfolio of 10% or even 20% cash in a portfolio. Future is inherently uncertain and I have realized over the years that forecasting the future with precision is a fools game. Quoting Howard Marks: "You can't predict but you can prepare." Investor can prepare by having some cash in their portfolio. Berkshire is preparing for the uncertain future by holding at least $20 billion in cash all the time. 

There is a lot of insights in Buffett's letters and his 2014 one isn't any different. Read it, study it and apply it. I'm sure readers will become better investors if they do. 


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