I hope this note finds you well and that spring is flourishing in your part of the world. I recently had the opportunity to attend my first Berkshire Hathaway shareholder meeting and wanted to pass along the following observations.
Investment management can be an intellectually fulfilling business that involves deep thinking and being surrounded by highly capable people. Value investing, in particular, is a uniquely alluring discipline as it provides a tangible framework – i.e., a repeatable model for making decisions based on the intrinsic value concept and common sense fundamental principles – amidst a financial world that otherwise can seem disorderly and fickle. Warren Buffet writes about how the value investing philosophy just “clicks” for some people when they’re first exposed to it. This was certainly the case for me -- I entered finance at the zenith of the technology bubble, which, at the time, seemed sensational and puzzling to me, and I remember how relieved I was to learn about value investing’s repeatable approach to rational decision making. The prospect of using the short-term vicissitudes of overly emotional markets to buy partial interests in superior businesses when they were clearly “on sale” seemed both prudent and satisfying. Furthermore, the canon of value investing literature provided ample content for a young professional who was interested in learning new concepts and collecting books. Early in my career at BBH, I found that studying the writings of investment greats, such as Graham & Dodd, Buffett & Munger, Philip Fisher, John Maynard Keynes, Adam Smith, and the like, formed what Bill Ruane referred to as “a good framework for the proper approach to investing.” It probably helped that I came from a liberal arts background and therefore had a relatively blank slate to start with. Over the subsequent 17 years, I’ve been fortunate to enjoy a career in the company of outstanding value investors and to have the gift of truly believing in the wisdom and efficacy of the services that we offer.
Although rules and theories can make perfect sense on a page, we know that in practice there are a multitude of conditions that contribute to make investing far more nuanced. I had a professor in graduate school who liked to drive this point home by saying that the financial theories we were studying were like “weightless elephants skating across frictionless surfaces.” The nine-year bull market that we are currently in has definitely put many of the central tenets of value investing to the test. As accommodative central bank policies have pushed equity markets higher, BBH’s investment discipline has resulted in above-average cash levels and our refraining from owning some of the market’s most popular momentum stocks. Couple this with an historic shift of capital into passive and “smart beta1 ” strategies that further stretch valuations and potentially pose structural risks to markets, and we have a challenging set of conditions for the risk-conscious value investor.
It is certainly possible that today’s investment environment could persist for some time, yet at BBH we don’t see the wisdom of relaxing either our valuation or business standards to chase returns. Investing through past cycles has taught us that market corrections can be swift and disproportionately destructive, and therefore “an ounce of prevention is better than a pound of cure.” In the meantime, BBH endeavors to execute our investment process consistently and to remain objective about any fundamental shifts that could challenge our approach. As an institutional Relationship Manager, remaining contrarian for an extended period can be a challenge; on a personal level, however, it’s gratifying that BBH has not wavered from our investment process and that we remain true to the principles that have been so successful over the years.
It was with this frame of mind that I traveled to Omaha for my first Berkshire annual shareholder meeting. There were several essential points discussed at both the annual meeting and at numerous events put on by attendees throughout the weekend. The most consistent themes related to the difficulty of finding attractive investment opportunities in today’s environment and the necessity of maintaining a long-term perspective.
What follows are a dozen takeaways that my colleagues and I had over the course of the weekend. We encourage anyone who has the time to read the meeting transcript (it’s 85 pages), but otherwise here are a few of BBH’s observations:
1. Ability to endure – BBH participated in the GuruFocus investment conference on Thursday and Friday before the Berkshire meeting. One of the presentations included an anecdote in which the presenter asked Jean Marie Eveillard what was the most important trait he looked for in an analyst. Eveillard responded that “it was the capacity to endure pain.” This was a recurring theme throughout the weekend as investors of various stripes commiserated over the necessity of remaining committed to behaving very differently than the markets in order to beat them over time. Making truly differentiated investment decisions requires a commensurate capacity to endure the frictions that occur while a thesis or cycle plays out.
2. Long-term thinking – One of BRK’s enduring competitive advantages as a company is having a time horizon of effectively forever. At BBH, we believe our ability to look out 5+ years is differentiated from the vast majority of investors who do not have the patience to wait for the true operating performance of the business to shine through. It is in situations where we can look past short term issues in a business and appreciate the long term potential that we hope to have a sustainable competitive advantage as investors.
3. Circle of competence – Investors need to be very careful not to overstate their true circle of competence. Buffett admitted making a mistake about the strength of IBM’s business and it’s pretty clear in retrospect that he may not have known enough to truly assess IBM’s competitive position and prospects. Later Munger noted “a lot of other people are trying to be brilliant and we’re just trying to stay rational…and that’s a big advantage.” Munger also talked about the amazing ability of people to delude themselves and justify their own bad behavior or bad decisions. With respect to investing, we always need to ask ourselves very objectively “Do we know enough about this business to make a good decision?” “How much do we really know about the management team we are partnering with?”
4. Pressure to Invest/Difficulty of current environment – Buffett noted that Berkshire Hathaway has over $90 billion in cash today and that three years from now he doesn’t want to be defending why the company has $150 billion in cash. He noted that the burden of proof was on him to show that Berkshire could still invest wisely. Both Munger and Buffett noted that they could buy back a considerable amount of stock. He also mentioned dividends as a possibility. Separately he noted that size is a big impediment for good investment returns and that Todd Combs and Ted Weschler were each managing $10 billion (up from $2 billion) in marketable securities and that is a big amount. Buffett then went onto state “the truth is I’ve got more assigned to me then I can handle at the present time….if you told me we had to put it to work today, I would not like the prospect.” It was interesting that Buffett didn’t mention the “punchcard approach” to investing. When he was asked about the airline investments, Buffett and Munger talked about all of the challenges that the airlines have faced historically and were pretty lukewarm in talking about the positives. They concluded by saying the airline investments were “not like See’s Candies.” Years ago they might have waited for a “fat pitch” in the strike zone, but that might not be possible today and Buffett has been extremely patient relative to most investors.
5. Importance of continuous learning – This is one of Munger’s key themes; he highlighted Buffett’s decision to buy Apple as an example of Buffett continuing to learn and develop, although Buffett acknowledged he could end up going “0 for 2” with Apple and IBM. Both Warren and Charlie also talked about how much they learned from owning bad businesses like the original textile mill and a department store in Baltimore.
6. What would you do differently if you were private? – This is a question that Buffett likes to ask CEOs. If they answer “nothing,” they are likely not being truthful. However, if they do answer the question, it can provide a lot of insight into what the threats or opportunities are for the business or the industry. At past meetings, Buffet has said he would ask managers which competitor would you put 100% of your net worth in and, after asking a handful of people, would have a sense of what the best business in the industry is. The easiest way to get to that information is by asking knowledgeable people good questions.
7. Importance of acting – The big mistake at Solomon Brothers and at Wells Fargo was the CEO not taking sufficient action when he realized someone had done something ethically wrong. From an investment perspective, Buffett and Munger knew both Larry Paige and Sergey Brin early on and were very impressed. They also saw how profitable it was for GEICO to purchase leads through Google. Nevertheless, they didn’t invest. That was a huge missed opportunity. They had all of the information they needed, but failed to act. They don’t feel the same about Amazon because the valuation there was much more expensive and they didn’t have the same insight.
8. Capital light vs. Capital Intensive Businesses – Despite the fact that Berkshire has bought a number of capital intensive businesses, Buffett still believes that growing, capital light businesses “beat the hell out of buying something that requires a lot of capital to grow.” Buffett said that he has taken approximately $2 billion out of See's Candies over the 45 years they have owned it. This amount of capital taken out of the business is 80x the purchase price, a truly staggering amount. This brings up two points: first is the cash flow generation power of a capital light business that truly has pricing power over its customers, and second, how paying a full price for a great business is often a better investment decision than paying a great price for an average business. As famously reported, Warren was willing to walk away from the See's purchase if the family raised the price by $5 million at the final negotiation.
9. Capital Allocation – Buffett’s successor must have a “money mind” and be a very good capital allocator. In fact, capital allocation should probably be the CEO’s main talent. Buffett noted that over the next decade including both retained earnings and depreciation, Berkshire is going to have to invest about $400 billion, which is more than the company’s total equity capital today. Good capital allocation is a vital skill for a high-performing CEO.
10. Everyone else is doing it – Buffett believes that this is the worst reason for doing anything.
11. “Medical costs are the biggest threat to American businesses.” – The country is spending as much on healthcare as it does on taxes.
12. Interest rates are the #1 question for Intrinsic Values – Buffett was asked about Berkshire’s intrinsic value and future investment returns. In his response, he highlighted how low interest rates are driving up prices for stocks and businesses and hurting future returns. He thinks that interest rates will move higher, but he noted that he could be wrong. He pointed to Japan as having had near-zero rates for 25+ years and, as a result, investment returns have been awful there.
Throughout the weekend, I couldn’t help but think of the quote by Harvey Penick, the legendary Golf Hall of Fame teaching professional, to “… Be yourself. Play within yourself. Play your own game.” Similarly, the weekend served as a reminder of basic fundamental principles and provided encouragement to focus on executing one’s strategy with discipline, regardless of the environment.
Omaha is a quintessential mid-western American city where life seems a little simpler and slower than it does in New York. Insulated from the noise and hassle of a metropolis, it was wonderful to catch up with people who share common investment DNA and to concentrate on core teachings. A shared perspective existed among the 40,000 or so people who were in town that provided a refreshing reprieve and left me reinvigorated about the wisdom of not compromising in response to challenging market conditions.
As always, we thank you for your support and invite you to reach out with questions or to discuss the Berkshire weekend in greater detail.
Head of US Institutional Relationship Management
As of 4/30/2017 Core Select holdings in Berkshire Hathaway is 6.9% and Alphabet Inc. (formerly known as Google) is 5.9%. Holdings are subject to change. Note, BBH Core Select fund as of 4/30/2017 does not hold the following securities: Apple, IBM, and See’s Candies.
For more complete information, visit www.bbhfunds.com for a prospectus. You should consider the fund's investment objectives, risks, charges and expenses carefully before you invest. Information about these and other important subjects is in the fund's prospectus, which you should read carefully before investing.
Investors in the Fund should be able to withstand short-term fluctuations in the equity markets and fixed income markets in return for potentially higher returns over the long term. The value of portfolios change every day and can be affected by changes in interest rates, general market conditions and other political, social and economic developments.
The Fund is `non-diversified' and may assume large positions in a small number of issuers which can increase the potential for greater price fluctuation.
Opinions, forecasts, and discussions about investment strategies represent the author's views as of the date of this commentary and are subject to change without notice. References to specific securities are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations.
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Brothers Harriman & Co. ("BBH"), a New York limited partnership, was founded in 1818 and provides investment advice to registered mutual funds through a separately identifiable department (the "SID"). The SID is registered with the U.S. Securities and Exchange Commission under the Investment Advisers Act of 1940. BBH acts as the Fund Administrator and is located at 140 Broadway, New York, NY 10005
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IM-2017-06-01-4029 BBH001951 Expiration Date 06/30/2018
1 Returns that can be generated from illiquid or private markets such as real estate and infrastructure which offer attractive risk return trade-offs and which can provide important diversification benefits when added to a conventional portfolio of equities and bonds.