Warren Buffett and Charlie Munger provided many insights when they answered questions for nearly 6 hours on Saturday, May 4th, during the 2019 Berkshire Hathaway Annual Meeting. The following 5 themes stood out as the most important for investors:
1. Meaning of Value Investing
Warren Buffett: The decision to buy Amazon’s stock was just as much based on value investing principles as a decision to buy a statistically cheap stock. Value investing is about estimating and valuing future cash flows, not about how low a Price to Book or a Price to Earnings ratio is for a stock.
Warren Buffett: You can pay too much for a wonderful business. There is a price where we could have paid too much for See’s Candies and it wouldn’t have worked out well as an investment. You can turn any investment into a bad deal by paying too much. What you can’t do is turn any investment into a good deal by paying a cheap price.
Warren Buffett: We are comfortable holding a lot of cash because we are operating on the assumption that we will have an opportunity to deploy it at very attractive rates.
Charlie Munger: Our problem in finding investments is that people are willing to pay higher prices than we are.
Warren Buffett: We could invest $100B in the next year, just not at the prices that we like. It is not in the interest of shareholders that we start behaving like everybody else.
Buffett’s disclosure that one of his two investing lieutenants bought Amazon’s stock in his portion of Berkshire Hathaway’s portfolio shortly prior to the annual meeting was perhaps the biggest piece of news. Yet as far as we can tell from Buffett’s answers, he did not choose to do the same with the much larger pool of capital that he manages for Berkshire.
The investing community has been having this debate for some time – does evolving mean starting to invest in high-expectation stocks of high quality, fast-growing companies? Or does it mean sticking to the tried and true approach of waiting for investments where the expectations embedded in the price are very pessimistic?
Buffett correctly points out that value investing is defined by estimating the intrinsic value of a business based on its assets and future cash flows and buying it with a big margin of safety relative to that value. That means that it can be completely consistent with value investing principles to invest in a stock with a high Price to Earnings ratio if one thinks that the value is much higher.
However, the higher the embedded expectations the more confident one has to be about the distant future of a business. Few businesses possess such predictability and few investors are so good as to have such long-term foresight about far-out business results. Buffett also reminded us that no matter how good a business is, there is a price at which it will make a poor investment. It seems like this is a fact that has been forgotten as more and more investors succumb to Fear Of Missing Out (FOMO) and fancy themselves such great business forecasters that they consider the price paid for their investments to be of only secondary importance.
Keep in mind that we are deep into a bull market, with high valuations and few bargains. Maybe you are one of the select few who can pay high valuations for stocks and still generate good returns based on your amazing business judgement. However, far more think that they can do this than actually can. Those who are not self-aware enough to stay within their circle of competence are bound to lose a lot of money.
As far as we know, Buffett and Munger have not changed their stripes – they are keeping a lot of cash on the sidelines and choosing to wait for genuine bargains. The recently announced deal by Berkshire to finance Occidental Petroleum’s acquisition by buying an 8% Preferred Stock and a Warrant that will allow Berkshire to participate in the upside suggests that Buffett is far more eager to get a high-probability low-teens rate of return than to imagine himself capable of figuring out Amazon’s future in 20 years.
Charlie Munger: You don't need a portfolio of 50 stocks if you know what you are doing.
Charlie Munger: If I took the 30 biggest transactions out of Berkshire [in the past] 60 years, what would Berkshire be? Not much. I mean we wouldn't be poor, but we wouldn't be rich either. Maybe once every two years we had a major opportunity. Not very many. (2)
Warren Buffett: We do not have any formula that calculates risk. We do our own calculation of risk vs. reward in every investment. ... We do not think that the results would be changed favorably by having lots of committees and lots of spreadsheets. ... The first question we ask is: "Are we reasonably sure we know what we are doing?"
There are two important and related insights here: you need to be very sure you know what you are investing in well and that you do not need to have many good investments to succeed. Most of the investment management industry is over diversified not out of an abundance of insight, but out of a combination of not having enough confidence in the insights they do have and a desire to hedge their business risk.
Don’t confuse conventional with conservative – conservative investing means having a high degree of confidence in your estimate of business value and then waiting for a very large gap between price and value to obtain a sufficient margin of safety. Almost by definition, you aren’t going to find too many investments that fit these criteria most of the time, so you need to make the ones that you do find count. Or you can do what many others do in investing – make your portfolio look very “safe” by loading up on so many large, well-known companies regardless of price that your returns almost mathematically cannot deviate from the market by too much in either direction. (Hint: For those contemplating the latter approach, save yourself the trouble and consider a broad low-cost index fund instead).
2. Nature of Business Quality
Charlie Munger: If you take the hundred biggest corporations in the United States in, say, 1900, there is exactly one left alive [among the list of today's 100 biggest]. But that [turnover on the list] didn't happen because everything got weak. It happened because the competition and the change got so strong. (2)
Warren Buffett: It is possible that the new technology platform companies will prove to have durable moats, but we have had trouble thinking through their future economics. We can understand their business now, but less so how they will evolve. We have tried to mitigate that by hiring people who understand these business models better, like Ted and Todd, and by trying to widen our circle of competence. However, we are very comfortable missing out on big returns as long as we have a good batting average on the investments that we do make.
Warren Buffett: Brands and retailers have always struggled for who has the upper hand. Recently the power has been shifting in the direction of the retailers like Amazon and Walmart.
Few companies remain dominant forever. You can think back to almost any period in history and find once-dominant businesses that have become greatly diminished over time. Kodak. Dell. Yahoo. Sears. General Electric. The interesting thing is that few would have been able to point to exactly what was going to cause these companies to become less relevant in advance. At the time it frequently seems like some of these businesses are unstoppable.
And yet most companies have been stopped or at least severely challenged. You have to allow for unknown unknowns – whether it be technological change, regulation or changing consumer preferences. Studying a business’s history is just the first step in company analysis and valuation – you then need to think through how things can change, and what factors have already started to deviate from the past.
In the last two decades the pace of change has accelerated, and the durability of companies’ competitive advantages has diminished. So you should be on guard against paying too much for seemingly entrenched companies and seek investment opportunities where there is plenty of margin of safety for the future to looks somewhat worse than the past and for you to still generate an attractive rate of return on your investment.
3. Rationality vs. Behavioral Biases
Charlie Munger: It's hard to be reasonable. There are a million tricks the human mind plays on its owner. That's what causes stupidity. Think of how many times you've said to yourself, 'Why in the hell did I do that?' (2)
Charlie Munger: People who say they are rational [should] know how things work, what works and what doesn't, and why. That's rationality. It doesn't help if you just know what's worked before, because if you know why, then you'll be better at it (2)
Charlie Munger: Both Warren and I feel it's our moral duty to be as rational as we can possibly be. A lot of people who are brilliant in some ways tend to make these utterly asinine decisions in other ways. We both tend to collect the asininities of the world in a kind of checklist. And we try to avoid everything on the checklist. (2)
Three ideas here for you to consider to make better decisions:
1. We are all biased, but we can be more rational if we systematically defend against behavioral biases
2. Having a high IQ is not enough to be a good investor, and it can be especially dangerous if it leads to overconfidence (e.g. Long Term Capital Management)
3. You can, and should use checklists to improve your decision making process. Focus on those things that have had a bad track record of working and avoid doing them.
4. Business of Investment Management
Warren Buffett: You should only invest other people’s money if you can have the kind of investors who will stick with you for the long term and not panic and withdraw funds during rough patches in the market.
Charlie Munger: People come out of the womb with the delayed gratification skill - we can’t teach it, we pick the people who have it.
Warren Buffett: You can invest small sums at much higher rates of return than you can large sums.
Charlie Munger: I have seen genius after genius with a good record, and pretty soon they have 30B under management and 2 floors of young men working for them. And away goes the good record.
You cannot invest for the long-term if your investors have a short-term time horizon. So if you have no idea who your investors are and you sell your services based on short-term performance – guess what? You can talk about being a long-term investor all you want, but in practice you will not be able to actually invest for the long-term if you hit a rough patch, which most investors will.
The investment management business is the ultimate scale business. Costs are largely fixed, profitability sky-rockets as assets under management grow. I have met very few investors willing to limit the size of their assets so as to maximize the outcome for their investors rather than for themselves.
For some it’s just blatant greed and not caring about their clients’ outcomes too much. However, I believe that there are many professional investors who do care, but somehow convince themselves that they are immune from the force of gravity that sucks out excess returns once assets grow to be too large that they know affects peers. Maybe they tell themselves that they hired a few new analysts, and that will offset the burden of the larger asset base. Or perhaps they figured out a new strategy to launch alongside with the original. Don’t kid yourselves – for most investing approaches, and especially for fundamental equity investing, managing many billions of dollars is not in your original clients’ best interest.
5. How to Learn and Evolve
Warren Buffett: You should expand your circle of competence if you can. I have expanded mine a little over time. But you should be pretty cautious.
Warren Buffett: If you want to grow your investment circle of competence you want to read a lot and study a lot of businesses. It is more competitive now than it was when we started investing, but if you build your circle and have the discipline to be patient and do nothing a lot of the time you can still do well.
Charlie Munger: It is amazing how much we learned over the years. If we hadn't the results wouldn't have been anywhere near as good. We needed to improve at each step to take it to a new level.
Buffett is the world’s most successful investor in large part because he was able to evolve his investing process where most other would have rested on their laurels and stagnated. It is incredibly humbling to see how these two people, the youngest of whom is well into his 80s, challenge themselves to learn and evolve even today. It is this unquenchable thirst to learn and expand their circle of competence that makes Warren Buffett and Charlie Munger so amazing. While there are many things about them which many of us will not be able to replicate, learning how to become the best investor that you can be is something that we can and should all strive for.
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This article was originally published on Forbes.com
Note (1): All comments attributed to Warren Buffett and Charlie Munger in this article are my based on my notes and best recollection from listening to the 2019 Berkshire Hathaway Annual Meeting and may not be exact quotes.
Note (2): Based on the interview with Charlie Munger by Jason Zweig published in the Wall Street Journal (https://www.wsj.com/articles/charlie-munger-unplugged-11556935195)