The Return of the Buffetteers

by John Price

A friend told me that on a recent exam she was asked to explain why Warren Buffett says that diversification is a protection against ignorance and that it makes very little sense for those who know what they are doing. Based on a discussion she had with a stock analyst a few days prior to the exam, she answered roughly as follows. Buffett could buy in such large amounts and had such a following that what ever he bought would go up in price. Then he would sell and take a huge profit. What grade would you give that answer?

None of the 11,000 people crowding into the Aksarben Stadium in Omaha Nebraska on May 4, 1998, for the annual meeting of Berkshire Hathaway, the company led by Warren Buffett, would have committed such a blunder. To a person, they knew that Buffett patiently waits until Mr. Market offers to sell a great company with predictable earnings growth at a discount price. Then Buffett buys all that he can afford with the assumption that he will hold it for life.

Can such a simple-minded strategy really give worthwhile returns? Once again, ask those who attended the meeting. Many would know that when Buffett took over Berkshire Hathaway in 1965, it was trading at $18 per share. Using it as a vehicle for purchasing and investing in other companies, he has guided it to the level where it is now trading at $70,000 per share, an annual return of 28 percent. Others would know simply that since they bought stock in this former New England textile company, it has been going up like clockwork in both share price and equity per share.

No one else comes close to Buffett’s record over such an extended period covering every type of bull and bear market. He is also unique in that this has been accomplished without the use of derivatives, hostile takeovers and leveraged buyouts.

After dealing with the business in five minutes, Buffett opened the meeting to questions. For almost six hours he told stories, joked and munched on See’s Candies, while answering question after question with care, relevance and wisdom. Many questions were also dealt with by Charlie Munger, the Vice Chairman of Berkshire Hathaway. The following is a selection of the answers given by this twosome fairly much taken straight from my notes. Enjoy!

• Avoid stocks with low returns on equity and capital.
• Time is the enemy of poor businesses, the friend of good businesses.
• With a poor business you may be lucky in that you pick the time that it gets taken over. However, it is no fun to own stock in a company in which you hope it liquidates before it goes bankrupt.
• Avoid "cigar butts," but we have a had a lot of soggy butts in our time.
• When presented with a new company, we can say "no" within 10 seconds. Technology does not get through our filter.
• Our central role is (1) to motivate the chairmen of our companies to keep working even though they are already very rich, and (2) to allocate capital.
• Buy stocks that you never want to sell; when you get a good business, buy for life.
• Ideal purchase: buy more of what you already like and have because the price is right.
• Insurance is the most important business at Berkshire Hathaway.
  Political campaign spending is an under priced commodity, it needs legislation to limit it.
• Berkshire Hathaway gets a 20 to 30% return on equity.
• Jack Welch (CEO of General Electric) gave his secret of life—go where the competition is weak.
• How do you beat Bobby Fischer? Play him at anything but chess.
• Fannie Mae and Freddie Mac could be hurt by rising interest rates but not nearly as much as people might think.
• Q. What keeps you awake at night? I don’t worry. We do the best we can. We don’t predict currents—just how different fish will swim in different currents.
• Coca Cola is the best large business in the world; amongst other things, it set the trend for a company to buy back its own stock.
• Is there a danger of Japan selling the U.S. Treasuries that it owns? When you ask such questions, always follow up with "and then what?" If Japan sold a billion dollars of U.S. Treasuries, what would they do with the money? They would have to invest in other U.S. securities.
• There are two questions managers of public companies must ask. (1) Do you keep the earnings or return them to the shareholders. (2) With the portion that you keep, what do you do with it?
• Not many analysts recommend Berkshire Hathaway—perhaps because it is not the stock for them to get rich on.
• Steps to selecting companies. (1) We start by only looking at companies we understand. (2) We observe whether or not the management is telling us the truth in the Annual Report and other publications. Are they the things we would want to know if we were buying 100% of the company. We avoid companies with annual reports full of PR gobbledygook. We want to be able to read the report and know the company better at the end.
• The Annual Report of Coca Cola is an enormously informative document. We first bought Coca Cola on the basis of its Reports and had no discussions with its management.
• Look for candid, clear, coherent prose. If a business has a problem, we would like to know about it. Honesty and openness is the best policy. We would like to see announcements at board meetings along the lines of "this is a very serious problem and we have no idea how to solve it."
• Because of the use of options and warrants, we estimate earnings for many companies could be 10% or more lower than what they state.
• Benjamin Graham was a wonderful teacher and said that you don’t have to be right about every company. If I [Munger] taught a course on company evaluation, I would ask the following question on the exam, "Evaluate the following internet company." Anyone who gave an answer would be flunked.
• Current factors influencing market prices: (1) return on equity, (2) low interest rates, (3) market perceptions.
• A valid criticism is that we should have bought more shares of the companies we already own; perhaps we missed the boat in some cases. Also probably we have issued shares that we shouldn’t have.
• Definitely think that the demand for silver exceeds the supply by approximately 150 million ounces per year.
• Intrinsic value: present value of future cash that can be taken out of the business. It easy to calculate for Coca Cola, but very difficult for Intel.
• Need various internal models to deal with reality. One model is not enough: "To a man with a hammer, every problem looks like a nail." [Munger]
• We try to assess managers as to whether they love the business or the money.
• Do not mind paying a manager a lot of money for good performance but I am bothered by mediocre managers getting large sums of money. Unfortunately the system feeds on itself and there is not much that you can do to correct this problem. The original Vanderbilt didn’t take any salary. These high management salaries have a pernicious effect.
• Can have a circle of competence for a particular industry, but not a circle of competence for individual companies within the industry. It's easy to say that the manufacturing of PCs will grow enormously over the next decade, but hard to say which company will dominate.
• We have decentralized Berkshire Hathaway to the point of abdication. The only thing we have centralized is money.
• Discount future cash flows at the long treasury rate. Businesses get credit for free cash. With the best businesses, you don’t need to keep putting in cash.
• Investing is the art of putting in cash now to get more cash later on.
• EBITDA [earnings before interest, taxes, depreciation and amortization] is a nonsense figure; it is absolute folly to take any notice of it.
• To understand a company, understand its products, its competition, and its earning power.
  The best way to teach finance is to focus on easy cases. For example, in 1904 anyone could see that NCR was a wonderful company.
• We like homey, Norman Rockwell types of companies.
• Learn all the accounting you can.
• The best book on my investment methods is by Larry Cunningham. He has done a first class job of organizing my letters to shareholders. If I had to pick a single book, this would probably be the one.
  I would be worried if I sold a stock at the top of the market because it would mean that I would be practicing the "greater fool" theory.
• It is instructive to do postmortems, but don’t get too carried away.
• My principle is to leave enough money for your children that they can do anything they want, but not enough so that they can do nothing.
• Volume, price actions, RSI have no place in our calculations.
• Deprecation charges are a good indication of the required capital expenditures. Avoid companies that have to spend like crazy just to stay in competition.
• Good businesses throw up easy questions for the managers and the board, bad businesses throw up tough questions.
• We are willing to wait indefinitely for the right price for the right stock.
• Scuttlebutt—you can’t do too much, but you should be interested in the company in the first place. It might form the last 10-20 per cent of the analysis. If it looks like a seven foot hurdle to start with, don’t touch it.
• Don’t worry about risk the way it is taught at Wharton. Risk is a go/no go signal for us—if it has risk, we just don’t go ahead. We don’t discount the future cash flows a 9% or 10%; we use the U.S. treasury rate. We try to deal with things about which we are quite certain. You can’t compensate for risk by using a high discount rate.
• We don’t worry about volatility, if we are confident about the business. For example, Washington Post went down by 50% after we bought it; it was a volatile stock, but not a volatile business.
  The best criterion is to buy businesses on the assumption that you will hold them for life.
• Dairy Queen [recently purchased by Berkshire Hathaway] is a lot different than McDonalds. For example, it employs a lot less capital. Nevertheless, McDonald’s still gets a good return on its capital.
• I don’t mind paying taxes. It is much better on this side than to be on the other side receiving government assistance.

The Mousketeers was never this much fun, even though back then we got to wear big ears.

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