This and That
Before I started blogging, I never imagined writing to be difficult. I mean, how hard is it to write an email right? And a blog is just two and half emails, right? And I was right -for a while. When I first started blogging two years back, it felt easy to say whatever I wanted. I had no readers or followers and I didn’t care about the consequences. Then, I made the mistake of publishing some of my blogs on Twitter, which brought me some attention. The reward centers in my brain liked it and craved for more. With attention came anxiety that I may end up saying something that I would regret. And that anxiety is now shackling the ‘free spirited’ blogger. And once the ‘free spirited’ blogger was shackled, there was no other writer- serious or otherwise in me. And thus, I struggled to write.
So here I am trying to strike a deal to with the same ‘free spirited’ blogger; to unshackle him, with the hope that he will unleash a few torturous writings on mankind in 1.4 M characters or less.
Back to Warren and Charlie
One of the most significant things I did in 2015 was to purchase the Kindle edition of Warren Buffett’s letters to shareholders and actually read it. Its an amazing collection of writings by an amazing man and his amazing partner. Even if you aren’t into investing, you should read it for the wit and wisdom in it.
And, one of the most significant things I did in 2017 is to print the letters and re-read them and this time I actually understood some of the stuff. So I decided to blog some ‘free spirited’ stuff on my understanding.
You have probably come across the following quote from Munger:
“How many insights do you need? Well, I’d argue that you don’t need many in a lifetime. If you look at Berkshire Hathaway and all of its accumulated billions, the top ten insights account for most of it. And that’s with a very brilliant man – Warren’s a lot more able than I am and very disciplined – devoting his lifetime to it. I don’t mean to say that he’s only had ten insights. I’m just saying that most of the money came from ten insights.”
So let’s say, we actually made a list of Warren and Charlie’s top ten insights, what would they be? When I first started to list the insights, I was making a list of Berkshire’s top ten investments. But on my second thoughts, I realized an insight could be more than one investment idea. For example, the purchase of See’s Candies and the subsequent experience of running a business with a great franchise taught Warren and Charlie the importance of investing in businesses with great underlying economics. And they didn’t stop with See’s; they subsequently invested in other companies with great franchises or great economics like Scott Fetzer, Coca Cola, Kraft, Gillette, P&G, Apple and so on.
I am going to list the 10 insights that I think are the best according to me; if you have a list, do share it along with your reasons. It’ll be fun to compare notes.
So here are five of the ten insights (in no particular order):
1. Investing in wonderful companies at fair prices rather than fair companies at wonderful prices
Most followers of Buffett would agree that the shift from investing in cigar-butts to investing in companies with wonderful economics has been the hallmark of Berkshire. In 1983, Warren Buffett said:
My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely upon economic Goodwill. This bias caused me to make many important business mistakes of omission, although relatively few of commission.
Keynes identified my problem: “The difficulty lies not in the new ideas but in escaping from the old ones.” My escape was long delayed, in part because most of what I had been taught by the same teacher had been (and continues to be) so extraordinarily valuable. Ultimately, business experience, direct and vicarious, produced my present strong preference for businesses that possess large amounts of enduring Goodwill and that utilize a minimum of tangible assets.
And this is what Warren said in 2015, in the letter titled: Berkshire – Past, Present and Future.
Charlie Straightens Me Out
My cigar-butt strategy worked very well while I was managing small sums. Indeed, the many dozens of free puffs I obtained in the 1950s made that decade by far the best of my life for both relative and absolute investment performance.
But a major weakness in this approach gradually became apparent: Cigar-butt investing was scalable only to a point. With large sums, it would never work well. In addition, though marginal businesses purchased at cheap prices may be attractive as short-term investments, they are the wrong foundation on which to build a large and enduring enterprise.
Once, the shift from Cigar-butt to companies with great underlying economics happened, Warren sought out and invested in other such businesses like Coca Cola, American Express, Kraft, P&G, Nebraska Furniture Mart, Scott Fetzer etc. Here is a thought experiment on Geico:
- Berkshire purchased the first ~ 33% for about $ 45 M from the secondary market in mid 1970s. At that time, due to mismanagement at Geico, the shares had fallen by 90%! Subsequently, Geico repurchased its own shares raising Berkshire’s stake to 50%.
- In mid-90s, when Berkshire purchased the remaining 50% of Geico, it paid, hold your breath, for $ 2.3 B. What a huge price differential between the first half and the second!
- Would Warren have bought it had he been still searching for Cigar Butts? And would he have paid such an exorbitant amount for it? You really have to evolve into a great thinker to be able to see these opportunities.
2. Too much of a good thing (float) can be wonderful
Berkshire loves the Insurance business. And the Insurance business has loved them back. In the Insurance business, premiums are paid upfront by customers and claims if any would come later. So for a duration of time, Berkshire gets access to this float that it can invest and earn returns on it. In 1965, Berkshire had one Insurance subsidiary giving it $ 39 M of float; in 2017, it has a large number of subsidiaries such as Geico, National Indemnity, Berkshire Reinsurance, General Reinsurance and their subsidiaries that give it a float of $91 B!!
However, just float alone is no good. You need the discipline to price your insurance products to have underwriting profits for a majority of the years, because underwriting profits mean that the float money comes cheap or better still- free! For the last 15 consecutive years, the Property Casualty companies of Berkshire have had underwriting profits. In 2012, Berkshire Re had $34 B of Float and significant underwriting profits. General Re produced the second largest Float and it was ‘cost free’.
Here is what Buffett had to say about Float in the 2012 letter. (Emphasis is mine)
This collect-now, pay-later model leaves us holding large sums — money we call “float” — that will eventually go to others. Meanwhile, we get to invest this float for Berkshire’s benefit. Though individual policies and claims come and go, the amount of float we hold remains quite stable in relation to premium volume. Consequently, as our business grows, so does our float.
If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit is earned, we enjoy the use of free money — and, better yet, get paid for holding it. That’s like your taking out a loan and having the bank pay you interest.
When Berkshire’s book value is calculated, the full amount of our float is deducted as a liability, just as if we had to pay it out tomorrow and were unable to replenish it. But that’s an incorrect way to look at float, which should instead be viewed as a revolving fund.
Berkshire has invested the float in buying other companies and marketable securities (equities, bonds, derivatives) which gives Berkshire more cash flows to buy more companies. And the float would just get bigger and bigger as the insurance operations get bigger making Berkshire one BIG snowball!
3. Economies of scale
A typical low cost-high volume player has the following model:
- Low overheads + lower avg buying price derived from large volumes
- Low mark up therefore leading to low prices for customers vis-a-vis competition
- Low prices leading to high volumes
This flywheel kind of concept is nothing unique and applies to almost all low cost- high volume players such as Walmart, Costco, Amazon, etc. Low cost offers a huge moat. Customers in 7 AD, customers in 1997, customers in 2007 and customers in 2017 all love low costs as will customers in 2027 and beyond. Buffett understood the underlying economics and purchased businesses such as Nebraska Furniture Mart (NFM), R C Wiley, Star Furniture and Geico.
With Berkshire at the helm, these companies were encouraged to go out there and secure as much business as they could on the back of low costs-high volumes and customer satisfaction. NFM went on to open large scale centers in Kansas and Texas; Geico went from a market share of 2% to nearly 10% on the back on increased marketing and low cost.
An observation: Remember Buffett’s famous line:
The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 per cent, then you’ve got a terrible business.
However, he doesn’t apply this yardstick (pricing power) to low cost-high volume operators and in my limited view that is right. In fact the low cost- high volume operators are encouraged to pass on the benefits that come with scale back to the customer, thereby widening the moat further.
This is what Buffett said in 1984 when NFM was purchased:
They (NFM) buy brilliantly, they operate at expense ratios competitors don’t even dream about, and they then pass on to their customers much of the savings. It’s the ideal business—one built upon exceptional value to the customer that in turn translates into exceptional economics for its owners.
And this is what he had to say about Geico in the 1990s.
Nonetheless, the economies of scale we enjoy should allow us to maintain or even widen the protective moat surrounding our economic castle. We do best on costs in geographical areas in which we enjoy high market penetration. As our policy count grows, concurrently delivering gains in penetration, we expect to drive costs materially lower.
4. Decentralized operations; centralized capital allocation
The fully owned Berkshire subsidiaries operate in a highly decentralized way. The operating managers / CEOs of the business are in complete control over their businesses and run their businesses just as they did before Berkshire purchased them. They have a simple dictum from Buffett – widen the moat; run the business profitably and return excess capital to Buffett to allocate.
This allows Buffett to focus on one thing- capital allocation. And with focus and lesser distractions, he has gotten better and better at it.
This is what Charlie had to say about Warren in the 2015 letter titled: Berkshire- Past, Present and Future:
Berkshire’s Chairman would reserve only a few activities for himself.
He would deploy most cash not needed in subsidiaries after they had increased their competitive advantage, with the ideal deployment being the use of that cash to acquire new subsidiaries.
In particular, Buffett’s decision to limit his activities to a few kinds and to maximize his attention to them, and to keep doing so for 50 years, was a lollapalooza. Buffett succeeded for the same reason Roger Federer became good at tennis.
How it operates:
- Say you are a business owner. By selling to Berkshire, you get paid in cash for the proportion of the business you sold (or Berkshire stocks if Warren is in a mood to relent). But you and all your associates get to keep your jobs and run the company just as before.
- You use as less capital as possible in your company’s operations. Your number 1 job is to widen the moat while delivering profits. If there are acquisitions to be made, you check with Warren, otherwise you make all the decisions with respect to the operations. At the end of the year, you send all excess profits to Berkshire. If you need guidance, check with Warren.
- Buffett would spend most of his time reading and learning; only when an opportunity to purchase came along, he would make the acquisition. He is free to invest in companies in any industry that he understands.
You can call it patience. Or use the sexier phrase that Warren uses- ‘waiting for the fat pitches’. They both mean the same: the ability to let the world go by and do nothing for long, long periods of time. But once in a while, the world gives you an opportunity to swing at an opportunity that you understand, is in your sweet spot – and you go for it! At other times, do nothing.
See this really short video to see what I mean.
End of Part 1
Reading the letters to shareholders is educational and entertaining. In order to write this blog, I had to go back and forth between my kindle highlights and my printouts. But its been fun. I am working on finishing up with the other insights in a couple of days. Meanwhile, do share your thoughts.