The common denominator of Gurufocus participants is their strive to mimic great investors, their results, their habits, mental models and world view. Wouldn't we all like those stellar returns and control over our destiny that comes with it? But similar to many other fields in life that offer promises of great riches: when many are called, few are chosen. This is no different in financial markets. The nature of the game is such that most participants have to lose to finance a small minority of big winners.
What does this tell the average market participant? It means that, apart from talent, mimicking great investors requires considerable effort in studying. It was no accident that Warren Buffett (Trades, Portfolio) packed his holiday bags with annual reports. It was the price he was willing to pay. It is also helpful to study other great investors. What did great investors buy? When did they buy? Under what circumstances and from whom? When did they sell and why? Like analyzing genius moves in a chess game, reverse engineering great investments can prove highly revealing.
One pitfall from this process is the acquisition of a trader's mindset. At first glance, trading profits, those resulting from profitable buying and selling, seem a considerable part of investment outcome and are the focus of most novices to experienced investors. It seems intuitive that without trading profits there can be no investment success, since for a portfolio to grow, instruments have to be bought and sold with a profitable result.
Yet, trading has its pitfalls. Those pitfalls diminish exactly the result the investor is trying to achieve. First, there is the risk of over trading, causing negative leakage from commissions and spreads. Second, trading incorporates the assumption of activity. The latter only benefits brokers and trading desks that aim for the spread. Indeed, those who have ever visited and analyzed an average professional trading desk discover the bulk of profits are gained from the spread.
For those of us paying those spreads, avoiding these and other pitfalls requires a deeper, almost X-ray type, examination of great investors. What would such an X-ray reveal? What information can we derive from looking at the inner workings of successful investment models or methods? At risk of overlooking an obscure unknown investor out there, the greatest achievement award goes to Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) as proved by their numbers.
Figure 1: Berkshire's book value change. From the Buffett 2013 letter to Bershire shareholders.
Figure 1 shows why Buffett and Munger deserve their credentials with an incredible 693,518% gain over an almost 50-year period, compared to 9,841% for their benchmark, the Standard & Poors 500 index. In Buffett's own words, "Over the last 49 years (that is, since present management took over), book value has grown from $19 to $134,973, a rate of 19.7% compounded annually." It's important to realize that this gain in Berkshire's book value is after tax, while the S&P gain is pre-tax. That is nothing but truly remarkable on any known measure.
Are these results a six sigma event? A lucky roll of the dice? The anomalous result of some guy with a photographic memory from Grahamville? Several academics have proposed this view, which might provide satisfactory explanation to the casual observer. But for more understanding, let's take out the X-rays and magnifying glass to see how these results came about.
To better understand the X-rays, first consider some Buffett and Munger quotes:
- "It's hard to make a continuous string of smart decisions like required for profitable trading."
- "All man's misery comes from his not being able to sit still in a room."
- "It's hard to make a good deal with a bad person."
- "The first few hundred millions came from holding our Geiger counter over the rubble. Then people wised up, and the bargains were gone."
- "If you owned a producing farm, you wouldn't care for daily quotes by real estate agents."
- "The market is a voting machine while company results are a weighing machine."
All these quotes have one thing in common: they reveal a thorough understanding of the power of positioning. In the context of investing, we could define a position as a conscious, consistent and structural method of relating to others.
Having a beneficial position precludes one from having to "do much." It frees oneself of seeking activity. For example, making continuous trades that generate the required compounding to produce Berkshire's results is almost an impossibility. The lack of a well publicized trading record spanning 49 years with similar results should be indicative.
Although at first glance Berkshire's returns seem the result of several investments, it is actually the structure of those investments that generated the compounded returns. We can therefore argue that Berkshire's X-rays reveal structuralism because having a successful 50-year winning streak on sheer discipline alone is almost impossible.
The career of Stanley Druckenmiller is noteworthy in this respect. Long on discipline, talent and a competitive attitude, Druckenmiller shut down his fund in 2010 complaining about the "high emotional toll." Many others have followed a similar path, from Steinhardt to Sperandeo. Comparing this "high emotional toll" to the always joyful demeanor of Warren Buffett (Trades, Portfolio) suggests he does things differently. That significant difference seems to be Buffett's better positioning. It was his positioning that generated above returns and enabled the holy grail of compounding.
The importance of correct positioning can not be understated. The first benefit can be derived from the Buffett-Druckenmiller comparison. Similar to Druckenmiller, Buffett came under increased investor pressure to go for higher returns in uncharted territory during the 1970s' go-go years. His answer was to shut down his partnerships while offering investors shares in Berkshire Hathaway. A clever and significant move, effectively decoupling himself from day-to-day, month-to-month or even year-to-year mood swings by fearful or greedy investors. Unhappy with his performance, his partners could just sell their Berkshire stock instead of getting Warren on the phone.
The second positioning move was Berkshire's entry into insurance in 1967 when Berkshire bought National Indemnity for $ 8,6 million. For that amount, Berkshire gained control over around $35 million in float. Put differently, instead of using the available $ 8.6 million to buy shares or bonds, Berkshire first bought National Indemnity which brought increased buying power. This two-step process almost guarantees a compounded return. First, the insurance company itself could grow, bringing in more float. Second, invested float will grow if invested wisely. An insurance company will growth at least with GDP. Similarly, float invested in quality businesses will also grow at least with the GDP percentage. But that result can only be achieved with quality management in place.
That brings us to Buffett's next positioning technique, to attract and work with only high quality people, those with integrity, energy and intelligence. Charlie Munger considers these virtues even relevant for a whole society. Lose any of those three pillars and the system breaks down resulting in significant problems for the owner, be it an individual business owner or a whole society. But as anyone who has ever hired people knows, attracting high quality is easier said than done. What positioning technique does Buffett apply here?
Working with and attracting quality people implies one to be of unquestionable character and to lead by example. Buffett and Munger show outstanding grasp of this concept. Both men's annual salaries are a mere USD $150,000. They thereby automatically signal out greedy applicants. Because how can one question excessive pay of others while one's own pay isn't conservative? In addition, how can one question the hubris of others while displaying it? That's why Buffett is happy living in the same house he bought for $34,000 in the '60s, and both men shun Ferraris, over-the-top parties and highly staffed 60-room mansions. Furthermore, how can one criticize money management compensation schemes if one charges them as well? So Buffett only took performance fees from his early partnership investors and shunned management fees. And finally, how can one claim a sense of responsibility and ownership while denying it to others? This shows the counterintuitive management style within Berkshire, to let managers run their show without micromanaging, without corporate planning and without mandatory budgeting.
Transferring these concepts from their personal to their business lives, Buffett and Munger love low-cost operations with the Nebraska Furniture Mart being the best example. Buffett bought it from the late Ms B., who induced so much fear into competitors that they wouldn't even consider opening competing stores. Geico and Clayton Homes are other examples. These are businesses with a strong moat by simply being big low-cost providers in their industries. This makes total sense from a strategic perspective. No competitor would consider attacking a well-established, low-cost provider that by default keeps strengthening its competitive position. The risk of never recouping the required investment is just too high.
Although above description is far from complete, the reader already gets a sense of the power of correct positioning. The financial results of Berkshire Hathaway are no accident. The careful reader will have noticed how the act of trading securities has moved to the background. Starting from 1967, the early years, buying and selling securities at Berkshire were tactical acts derived from a strategic plan that shows how Buffett and Munger carefully positioned Berkshire for maximum results. Naturally, the X-rays of their 50-year track record reveals many more positions. Those will be discussed in the next article of this series. For now, readers are challenged to identify their own structural setup to produce favorable long-term results.
Sources:
- Warren Buffett (Trades, Portfolio). 1967 to 2013 annual letters to share holders.
- Alice Schroeder. The Snowball: Warren Buffett (Trades, Portfolio) and the Business of Life.
- Roger Lowenstein. Buffett: The Making of an American Capitalist
