Invert, Always Invert

I Wouldn't Start From Here

“All I want to know is where I’m going to die, so I’ll never go there” – Charlie Munger

Carl Gustav Jacob Jacobi was a nineteenth century mathematician famous for his work on elliptic functions, amongst other accomplishments.  Oddly he ends up being frequently quoted by Charlie Munger and Warren Buffett, despite having no known connection with the investment world.

Jacobi's great contribution to investor thinking was his maxim “man muss immer umkehren”: invert, always invert.  Of course, Jacobi was actually making a statement about mathematics, not investment thinking, but we shouldn’t much care where we get our models from, as long as they have the distinct advantage of being useful.

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Salience is Golden

New Frames

As so often in the past Warren Buffett has stirred up a swarm of annoyed investors, this time by explaining why he thinks gold as an asset class isn’t so much overvalued as irrelevant. He’s done this in a way typical of the man, by changing our frame of reference, to give us an entirely new perspective on the issue.

This gives us an insight not just into gold's current status as an investment class but also into why Buffett is almost unique as an investment guru. He doesn’t rely on the old arguments about what’s important by drawing on existing ideas of what’s salient, but develops new ones, based on his own models. He changes what’s salient, and that’s real gold for investors.

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Warren Buffett Bias

Danger, Buffett Speaks

It’s a racing certainty that more people have lost money following the wisdom of the Sage of Omaha than following tips from any number of other so-called gurus. Of course, it’s perfectly correct that virtually every pearl of wisdom dripping from the lips of the Chairman of Berkshire Hathaway is worth a thousand utterances from the plethora of mass market media mavens masquerading as psychic predictors of the unforeseeable. Unfortunately there are two sides to every equation and Buffett, hard though he tries, can only be on one of them.

The simplicity of Buffett’s approach and his folksie wisdom belie a tough-minded and intensely focused individual whose career has been marked by a single minded determination to make money. Most people don’t see this, though, what they see are the incredible gains that can be made by actively trading and draw the obvious, but mad, conclusion that what’s good enough for the one person capable of defying the logic of markets is good enough for them. Following Warren Buffett without Warren Buffett’s temperament is a one-way ticket to the poorhouse.

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Why Markets Crash

An Unsteady Aim

Oddly there’s little agreement amongst the experts about why markets crash. Although given that experts in fields without objective measures of success are generally less accurate than a drunk in a ship’s urinal during a storm that’s not really surprising. Still, if the best that the world of investment has to offer doesn’t know when stuff’s overvalued then how can we possibly hope for an end to boom and bust?

There’s no getting away from the reality that the inability of analysts to know whether markets are overvalued or not leads to serious problems. Pundits, who have a record of prediction that makes amateur astrologers look like geniuses, are delighted to proclaim the inadequacies of regulators and analysts but, frankly, have nothing better to offer. Sadly, history doesn’t offer much in the way of solace: it’s only hindsight that gives us superior knowledge.

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Investing Like Berkshire Hathaway

Running the Quality Check

So how do we explain The Buffet Munger Paradox? It’s perfectly clear that the gentlemen in question don’t have a problem, but how does Buffett’s demented focus tie in with Munger’s breathtaking scope?

The answer’s simple, of course. Munger’s mental models are the framework upon which Buffett’s ideas are arrayed. Munger’s the quality check on Buffett’s biggest adventures.

Great Businesses at Good Prices

Buffett often says: We prefer to buy great businesses at fair prices than good businesses at low prices. This wasn’t always the case – indeed most of the Buffett Partnership’s investments were often in very poor businesses trading at exceptionally cheap prices – classic Ben Graham type heavy discount to net asset plays. Buffett’s change of focus was coincident with the start of the second phase of his career, as he started to build the web of businesses that led to the Berkshire Hathaway consortium he presides over today.

It seems highly unlikely that Buffett’s investing style changed entirely of its own accord. Warren Buffett is, and always has been, very much his own man but the influence of Munger’s broad based approach can be seen across all of Berkshire’s long term investments both partially and wholly owned.

Earnings not Capital

What Berkshire do is simple to analyse, largely because both Buffett and Munger tell everyone. Yet almost no one can do what they do. They’re contrarians on a grand scale, but their focus is on long term investment because they don’t view companies as pools of capital, to be traded. Berkshire is not, in general, investing for short-term capital gain.

What Berkshire does, and the Buffett Partnership never did, is treat companies as long-term earnings streams. In this model the capital doesn’t matter, because Berkshire never intends to flip its investments. However, to make this model work the companies that Berkshire invests in need to have a bunch of very specific qualities – it’s not enough to buy an average company at a low price because that will never generate the long-term earnings needed to make their model work.

The Four Point Investor’s Checklist

Buffett told us this back in the 2007 Letter to Berkshire Hathaway shareholders:

Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag. We like to buy the whole business or, if management is our partner, at least 80%. When control-type purchases of quality aren’t available, though, we are also happy to simply buy small portions of great businesses by way of stockmarket purchases.

Understand that statement and you’ve found the heart of the Buffett Munger paradox. These four qualities are all that Berkshire needs to make its long term earnings stream model work:

a) A business we understand. Don’t confuse this with the nuts and bolts of the businesses they own – this is about understanding the financials and business models. That’s where they add value – they’re managers of capital, not operating companies.

b) Favourable long-term economics. It’s all about the moat. It’s about finding businesses that have a sustainable business advantage that can’t be easily overcome by competitors.

c) Able and trustworthy management. Obvious, one hopes. Not so easy to do for private investors.

d) A sensible price tag. Sensible, not necessarily cheap but one that will provide good returns to shareholders if held over a long enough period.

Buying companies with these characteristics allows Berkshire to invest in companies whose earnings – profits – will reliably increase at an above inflation level over many, many years. Which means that it can ignore short-term issues and focus purely on making sure that the other piece are in place.

Analysing Buffett and Synthesising Munger

It’s easy to see that Buffett’s ruthless pursuit of a financial margin of error ties in beautifully with Munger’s broad based synthesis of ideas to cross-check investment proposals. It’s not just that the businesses need to be good, it’s that they need to offer sustainable long-term business advantages and checking that requires a wide range of mental models, because a single one isn’t going to do the job under all circumstances.

Consider the different types of business and circumstances that Berkshire’s invested in. Wells Fargo was originally bought during the Savings & Loan crisis in the 1990’s. Buffett’s analysis was the margin of safety was sufficient to protect Wells against the worst of the downturn (it was, barely). However, it’s the broader analysis that identified the bank’s management and processes as offering long-term competitive advantages. Buffett bought more of Wells Fargo last year, of course. American Express was another crisis investment, Washington Post was bought at a huge discount to net assets and Coca Cola bought opportunistically at moments of peak investment fear.

In their partnership Warren Buffett is very much the senior partner, with effectively a controlling stake in Berkshire. Some of the company’s more risky investments look very much as though Buffett pulled the trigger – Salomon Brothers and GEICO, for instance. Typically the company escaped with a decent return because of Buffett’s relentless focus on margin of safety, but it’s sometimes been a close run thing.

Share Price is Not .. So .. Important

Let’s return to the 2007 shareholder letter:

I should emphasize that we do not measure the progress of our investments by what their market prices do during any given year. Rather, we evaluate their performance by the two methods we apply to the businesses we own. The first test is improvement in earnings, with our making due allowance for industry conditions. The second test, more subjective, is whether their “moats” – a metaphor for the superiorities they possess that make life difficult for their competitors – have widened during the year.

Share price is not important, sustainable earnings are. In a market environment such as we have today that ought to be writ large through every investor’s heart. Buffet even tells us how to go about looking for the good companies:

To sum up, think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.

By “adding money” here Buffett means that the managers of your company have to keep re-investing your earnings at an increasing rate to stay still, rather having you shovelling new money at the business. Ironically “gruesome” was exactly the type of business that the original textiles based Berkshire Hathaway was. It’s interesting that they kept it going despite its poor return on capital until it could no longer maintain even a pretence of profitability: there’s more to Buffett and Munger than money, there’s humanity too.

Savers or Speculators?

So to be successful ultimately you only need to avoid the last kind of business as long as you don’t let share prices jerk you into buying and selling all the time. The last word, as ever, should go to Buffett himself (from the 1999 shareholder’s letter):

If you expect to be a net saver during the next 5 years, should you hope for a higher or lower stock market during that period?”Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall.”This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.

Hallelujah to that.


 


Related Posts: The Buffet-Munger Paradox, Is Intrinsic Value Real?

The Buffet Munger Paradox

Financial Focus or Latticeworks of Mental Models?

Warren Buffett and Charlie Munger, Chair and Vice-Chair of Berkshire Hathaway, are the most successful investors of all time as measured by monetary value, insight and wit. Don’t underestimate the intrinsic value of those latter two components – to retain senses of proportion and humour in the face of wealth unimaginable to the majority of us should immediately mark out these men as having characters extraordinary.

Yet at the heart of this enduring relationship is a curious paradox. When asked to identify the most important factor in his financial success Buffett replies with a single word: “focus”. Munger, on the other hand, extols the need for investors to develop a broad education in which to ground their investment activities. How can we reconcile these two different approaches?

Buffett’s Focus

Everything about Warren Edward Buffett seems to spring from a hunger, a focus, for making money. An early photograph shows him holding his favourite toy – a coin counter. By age 19 he had amassed the small fortune of $10,000 through various moneymaking schemes from paper rounds to a pinball machine hire business. He went to Columbia in pursuit of Ben Graham, maxed out on his courses and then pestered Graham until he gave in and made him the first non-Jewish employee of his firm.

When Graham retired Buffett packed his New York bags and returned to his home town of Omaha where he set up his own partnership, raking in fees based on profits made on capital from his investors with one single rule: astonishingly he wouldn’t tell them what he was investing in. They weren’t complaining – the young Warren made money hand over fist by taking Ben Graham’s lessons and applying focus – small and concentrated portfolios of value based stocks. The Buffett Partnership made 20%+ per year through the late fifties and sixties until, out of the blue, Buffett announced that he was winding up his investment firm.

Folding His Hand

Buffett had made the calculation that his tried and trusted investment techniques would no longer work in the booming markets of the late sixties: value was dead, as periodically happens. Unwedded to convention and with the clarity of vision that many other so-called gurus can only dream of, he coolly assessed the situation at the table where he’d won so much money, folded his hand and walked away. Within months the markets started crumbling.

In winding up the Buffett Partnership and distributing the funds to his shocked investors there were a couple of stocks left over that he also distributed, remarking that he believed that these would offer above average growth over the coming years. Unremarked amongst them was a failing textiles company called Berkshire Hathaway.

Most people who met the young Buffett were impressed by his focus, his intelligence, his energy and, above all, his honesty. Amongst the many who were wooed was a young lawyer, introduced to Buffett by a mutual friend: a dude by the name of Charles Thomas Munger.

Munger’s Mental Models

Munger stays in the shadow of Buffett, largely because that’s the way he likes it. Whereas Buffett is happy to write for the popular press, is delighted to pick up the phone to talk live to financial commentators on TV and loves nothing more than a big gathering of business people Munger shies away from the limelight. Even at Berkshire Hathaway’s AGM’s legendary question and answer sessions Munger lets Buffett do most of the talking.

So when Charlie Munger does decide to say something it’s usually something worth listening to and something that bears thinking about. And what he mostly talks about is mental models.

The core concept behind Munger’s philosophy is what he calls a “latticework of mental models upon which to array ideas”. He believes that people who approach investing with a limited set of mental models are bound to fail when situations change. Perhaps his greatest scorn is reserved for that part of the academic community which sponsors the Efficient Market Hypothesis – this, he believes, is a perfect example of a group who have a single model which they apply to all situations and all times.

When the evidence shows that they’re wrong rather than changing their model they change the evidence required. Munger calls this “man with a hammer syndrome”.

A Snowball’s Chance in Karnataka

To escape this trap we need to take ideas from all sorts of different areas, many of which have little or nothing to do with investing. Munger’s ideas range over areas as diverse as psychology, physics, biology, history and economics. Yet very often the point he’s trying to make gets lost in the detail as investors try to figure out which models to use from these subjects. That’s not – quite – the point.

Assume you lived in Southern India five hundred years ago and some stranger arrives and starts telling you about a strange phenomenon called “snow”. It’s white, it’s wet, it’s cold, it falls from the sky, lies about for ages and you make men out of it. Would you believe them?

Well, if your only model of the world is that you’ve experienced at home then the likelihood is that you won’t because snow isn’t something that you’re going to have personally witnessed. However, if you’re widely read and a budding philosopher or scientist you may be able to do a little better than simply dissing the idea – for a start you know that there may be things out there that you’ve never experienced, so you don’t dismiss it out of hand. But how can you decide whether this “snow” stuff is imaginary or not?

Arraying Your Knowledge

As you’re a student of physics or psychology you’ll know a few tricks of your own. You can probe for a few simple inconsistencies and to ask for some corroborating evidence – like what kind of clothes do people wear and does it snow all the time? With a few simple ideas you can perform enough of a cross check to conclude that, on the balance of probabilities, this stranger isn’t completely mad.

This is Munger’s concept of mental models. You don’t need to know everything but when that financial advisor arrives with his sheaves of papers showing the unbelievable returns to be gained from the new Ponzi bonds you need to know enough to crosscheck the ideas and the figures. To run a sanity check.

So all “arraying knowledge” on a mental model means is that when you come across new concepts you need to test them against multiple, pre-existing models. If all you have is a single model – it doesn’t snow in India – you won’t be investing in the new fangled refrigeration. Watch that fortune just walk out the door.

Focus or Mental Models?

So on one hand we have the incredibly focused Warren Buffett. On the other we have Charles Munger and his bag of broadly focused mental models. And back in the early seventies they started the process of integrating their investments into the behemoth has become Berkshire Hathaway. Unlike most investors, who suffer from the Law of Big Numbers – the increasing difficult of generating large returns from larger and larger amounts of capital – Buffett and Munger have carried on generating 20% per year.

Despite their apparently widely differing approaches they’re obviously doing something right. So how, exactly, does this partnership work?

To be continued in: Investing Like Berkshire Hathaway


 
 
Related Posts: The Rediscovered Ben Graham, Is Intrinsic Value Real?, Warren Buffett Bias

Is Intrinsic Value Real?

Intrinsic Value Means Different Things to Different People

The doyen of all value investors is Ben Graham, whose investing style was based around the concept of “intrinsic value”. For Graham intrinsic value was fundamentally about buying companies trading below NTAV (see Shoot the Company – Valuing By Assets). However, his most famous pupil, Warren Buffett, has redefined the concept to mean something rather different.

So if intrinsic value means something different to different people and changes its meaning over time, what’s the use of it? Is it real or illusory?

Margin of Safety

Ben Graham’s heyday was the 1930’s and 1940’s when he trashed the markets by averaging a return of around 20% a year. Brilliant though he was he still nearly went out of business in 1930 after he geared up to take advantage of cheap stocks following the Wall Street Crash. The subsequent second wave collapse nearly wiped him out, although with the aid of a timely loan he was able to make his, and his investors’, losses back in the next two years. He was ever after wary of gearing.

For Graham intrinsic value was about buying a company for less than it was worth, based on its net assets. His aim was to buy companies with a sufficient margin of safety so that if the company’s performance was less good than expected there would still be the underlying asset value to rely on. On the other hand if the company’s performance was better than expected the price would respond positively.

In those decades you could hardly give stocks away to Americans, stunned and made risk adverse by the collapse of the markets in ’29 and ’31. There were swathes of companies meeting Graham’s criteria at valuation levels that haven’t been seen again until, well, now. Even now it’s a lot more difficult to find decent stocks trading at a discount to net tangible asset value. (And Graham actually set an even tougher hurdle than this, a discount to net tangible current assets – excluding anything that couldn’t instantly be turned into cash).

Buffett Continues the Graham Way

Warren Buffett is Graham’s most famous pupil and initially made his money by trading the Graham way – although characteristically he put his own stamp on this style by savagely curtailing the number of stocks he held. When Graham shut up shop Buffett set up his partnerships and continued on until the end of the sixties.

At that point he shut the partnerships down because he could no longer find the cheap stocks that he and Graham had made their money with. He was dead right of course – it was nearly twenty years before markets rose again in real terms. His disappointed investors wound up with a bunch of cash and a few shares in some unknown failing textiles company called … Berkshire Hathaway.

Intrinsic Value Mutates

From 1970 onwards Buffett’s style of investing changed and with it the definition of intrinsic value. This seems to have part been a response to the changes in the market and part due to the influence of his partner, Charlie Munger. What they now started to do was to look for companies with the ability to grow their earnings in the long-term.

Arguably this was a switch from a value investing to a growth investing style. However, there’s a crucial difference between normal growth investing and Berkshire type growth investing: the target companies must have some feature about them that means long-term earnings growth is assured, this is not speculative. Buffett says that growth and value are both part of the valuation equation and central to this is intrinsic value, modern style – the feature required in investments to make this long-term growth realistically achievable.

Long-Term Growth is not Predictable

The problem with this, as any investor knows, is that predicting a company’s earnings from one year to the next is just about impossible. (At the moment they can’t even do it from week to week). So it’s important to note that Berkshire doesn’t expect smooth growth in earnings on its investments, but it does expect to see a substantial growth in earnings over time. The concept of intrinsic value is essential to this – a Buffett and Munger type investment is one that’s trading a significant discount to intrinsic value.

The word “significant” is, well, significant – intrinsic value is not an absolute number that you can pin down. It’s a range of possible values which are largely dependent on the long-term ability of the company to grow its earnings. Because future earnings growth is always dependent on stuff that’s, err … in the future, this can only be, at best, estimated.

Intrinsic Value and Moats

This should give some clues to what intrinsic value is about. The investment has to be a company that can pretty well guarantee a long-term increase in earnings over and above what you’d expect the market to provide (otherwise you might as well invest in an index tracker). Yet as future earnings are, by definition, an unknown this suggests some interesting requirements about the nature of the target company.

What type of company can virtually guarantee a long-term increase in earnings? Well, in Buffett terminology, it’s a company which provides something essential and has a defensive moat that prevents competitors from muscling in. Any company serving a market in which competitors can easily enter will eventually struggle to grow at more than the market rate – this is simply Adam Smith’s invisible hand in operation as competition drives down prices and margins. So any company with real intrinsic value has some kind of moat.

Looking at Berkshire’s main investments it’s pretty easy to identify the kinds of stuff this translates to. Coca Cola’s brand and distribution network is nigh on impossible to break down. The Nebraska Furniture Mart is the biggest distributor of its kind in the Mid-West and uses its buying power to get stock cheaply and pass on the savings to its customers. Sees Candy has the best customer service reputation of any business in its class. Berkshire’s insurance companies use their financial power to either beat the opposition on price or, when necessary, to refrain from quoting in order to not make losses on policies. Buffett will even incentivise staff not to write business on some occasions.

Intrinsic Value and Margin of Safety

These moats are simple but powerful and properly managed they provide companies with enormous long-term competitive advantages when backed by a management prepared to ignore short-term fluctuations. However, there is a problem with this: generally any company with such a built-in advantage will trade at a premium to other companies on the stockmarket. They’re expensive and this expense destroys the margin of safety which Graham would have insisted on.

Buffett also insists on a margin of safety. So how does he square this circle?

Stockmarkets are Dumb

Remember that he’s looking for a discount to intrinsic value where intrinsic value is the long-term value of the earnings stream that the company can generate. However, the stockmarket, being a creature with no memory and precious little intelligence, generally values companies based on short-term earnings. Which means that sometimes, although not often, the premium that well-moated companies trade at disappears.

One of Buffett’s maxims is that he prefers to buy great companies at fair prices than fair companies at cheap prices: a recognition that companies with a high intrinsic value will rarely trade at really cheap prices. However, a great company going through a temporary blip may occasionally trade at a fair price and by buying that company at such a price he gains access to the long-term earnings stream that it will provide when normal service is resumed.

Because history shows that, for anything other than dying industries, normal service will be resumed. Humans overweight the short-term and underweight the long-term. By effectively ignoring this and buying companies trading at a discount to intrinsic value Berkshire obtains access to a long-term income stream at a discounted price.

Intrinsic Value works in the Long-Term

There is one caveat to this – the company must do something that will continue to be required for a long time. Buying a cheap company in a dying industry is exactly the wrong thing to do. Which is ironic because, of course, that’s exactly what Berkshire Hathaway was when Buffett bought into it. Still, his investors aren’t complaining even though their stock has seen significant paper losses this year. Buffett and Munger are still investing with their eyes on the next twenty years, ignoring the short-term chaos in the markets and focusing fiercely on intrinsic value.

There’s a lot of it about, if you’re good and brave enough to spot it.