Thoughts on Share Repurchases and Capital Allocation

The concept of share repurchases is not particularly complicated.  Repurchase programs allow companies to allocate capital toward purchasing its own shares either on public marketplaces or through privately negotiated transactions.  Capital allocation is one of the most important recurring functions of management, at least for companies that regularly generate positive free cash flow.  Share repurchases represent one of many options for allocating free cash flow.  This week, Berkshire Hathaway surprised many investors by amending its share repurchase program in a way that dramatically increases the odds of repurchase activity in the years to come.  Berkshire’s program is relatively unusual and worth considering in some detail, but first it might be useful to step back in order to review the overall concept of share repurchases and various stigmas that have come to be associated with the practice.

Capital Allocation 101

From a financial standpoint, the purpose of any enterprise is to generate positive free cash flow that justifies the level of capital that investors have allocated to the business.  Despite many creative approaches to value companies that grow more popular toward the conclusion of every bull market, the only conservative way to look at business valuation is to consider the power of the business to generate free cash flow and its prospects for deploying that cash flow over time.  Free cash flow is simply defined as cash generated by the business in excess of reinvestment required to allow the business to maintain its competitive position and earnings power.  Although there are a number of approaches used to calculate free cash flow, which does not have a firm definition under generally accepted accounting principles (GAAP), most investors use some variation of taking cash flow from operations and subtracting maintenance capital expenditures.  Some judgment on the part of investors is required to determine what percentage of overall capital expenditures are for “maintenance” versus “growth” and few managements explicitly report this figure.

For purposes of this discussion, assume that you are confident in your assessment of free cash flow.  As an owner or potential owner of a business, the question becomes how management should allocate this free cash flow in a manner that maximizes your wealth in the long run.  There are only a few options for management to allocate free cash flow:

  1. Expand current business operations.  If there are growth opportunities within the company’s current line of business that can be pursued by allocating additional capital, and if those opportunities promise to yield an acceptable return on incremental invested capital, most management teams will opt to pursue expansion.  After all, doing so continues to leverage management’s core skill set and incremental expansion is something most managers will feel comfortable pursuing.
  2. Pursue business opportunities in adjacent or unrelated areas.  Management may find limited growth opportunities within the company’s current line of business but see opportunities for expansion in related adjacent markets or even in unrelated areas.  The level of risk involved in this type of investment is generally higher than reinvesting in the current line of business and expected returns on capital would need to be commensurately higher to justify investment.
  3. Pursue acquisitions.  Management may pursue acquisitions either within the company’s current line of business, in adjacent businesses, or in totally unrelated areas.  In the latter case, management would be pursuing a conglomerate strategy if they enter into multiple lines of unrelated businesses.  Obviously, the expected return on acquisitions must justify the investment and management should not be pursuing this merely to expand the size of the company for the sake of size itself, which is not an uncommon motive since compensation generally rises with the size of a CEO’s “empire”.  Pursuing a conglomerate strategy is risky and would require a versatile and talented management team.
  4. Accumulate cash.  If management cannot find current opportunities to deploy free cash flow through internal or external expansion, they can accumulate this cash flow on the balance sheet until such time that opportunities emerge that warrant investment.  However, accumulation of excess cash suffers from many problems including minuscule returns and the risk that management will feel like that cash is burning a hole in their pocket which can often lead to poor decision making.  The cash can also be misallocated toward unjustifiable executive compensation.
  5. Return capital to shareholders.  Lacking viable investment opportunities logically leads shareholder oriented management teams toward looking for ways to return that capital to shareholders.  Shareholders will then reallocate this cash themselves by investing in other businesses or using the cash for consumption, both of which have the potential to generate productive uses of the capital.  Capital can be returned to shareholders through dividends or share repurchases.

Return of Capital

The best businesses are those that generate massive amounts of free cash flow relative to capital invested and managers have ample opportunities to allocate that cash flow toward investment opportunities that also generate massive cash flow relative to that incremental capital.  In reality, this type of business is extremely rare.  More common and still attractive are businesses that generate significant free cash flow but have trouble expanding at attractive rates of return.  Examples abound but one that comes immediately to mind is See’s Candies, one of Berkshire Hathaway’s longest held subsidiaries.  See’s is capable of generating extremely high returns on invested capital but it has been very hard for See’s management to expand the business beyond the markets in the western United States that it already dominates and it has also been difficult to expand the overall market for boxed chocolates.  See’s cannot redeploy all of its cash flow internally so it remits the cash to its controlling shareholder which is the parent company, Berkshire Hathaway.

Returning capital to owners is not admitting failure, nor should it be any kind of stigma against the management team.  Some businesses are cash cows and should be treated accordingly.  The stigma should arise from allocating cash from a cash cow in a manner that destroys value.  And it is not difficult to destroy value by allocating incremental capital toward sub-par projects while the evidence of the folly is somewhat disguised since the company’s overall return on capital will still be attractive.

To repeat, capital allocation of free cash flow must generate an attractive incremental rate of return on that reinvested capital.  If this is not possible, it should be returned to owners.

Taxes, Taxes, Taxes

Why are the best businesses those that can generate massive free cash flow and profitably redeploy that cash flow internally?  Well, although they will not escape the corporate layer of taxation, such companies can grow internally and avoid paying dividends to shareholders which means that individual shareholders will not have to pay a second layer of taxation.  This is incredibly valuable.  It is the duty of managers who do not have the ability to reinvest internally to return capital to shareholders in a way that minimizes tax consequences.

Payment of a cash dividend is the most straight forward way for a company to return capital to shareholders but it is also the least flexible and most impactful when it comes to tax consequences.  All shareholders of the company will receive a pro-rata share of the cash dividend (putting aside cases where there are multiple share classes with different entitlements to distributions).  Shareholders holding stock in taxable accounts will have to pay income taxes on the proceeds.  Many companies establish regular cash dividends which they attempt increase over time.  This tends to attract a shareholder base that appreciates regular payment of dividends and is presumably less sensitive to the fact that the dividends incur taxes.  Whether used for investment in other companies or for consumption, the tax drag makes the payment of cash dividends inherently inefficient.

Regular cash dividends also promote potentially suboptimal management behavior.  Once established, a regular dividend typically cannot be reduced or eliminated without sending negative “signals” to the market regarding management’s view of the company’s future prospects.  As a result, all kinds of irrational behavior can occur to continue paying dividends at times when there is no free cash flow to pay out.  This can lead a company to take on debt to continue paying dividends or even to issue new shares for that purpose (which, in extreme cases, can resemble a Ponzi scheme).  Special dividends can alleviate part of this problem.  A special dividend is one that is not expected to recur and managers are more free to use this approach only at times when it makes sense.  However, special dividends, or dividends set based on some predefined formula such as the one Progressive uses, are quite rare.

Repurchases:  A Tax Efficient Return of Capital

If executed properly, a share repurchase program can be a very efficient means of returning capital to shareholders.  Unlike cash dividends, the only shareholders who have tax consequences as a result of a repurchase are those who voluntarily sell their shares back to the company, either in open market transactions or through a negotiated private sale.  Share repurchases, unlike dividends, are not presumed to occur on a regular schedule and there is generally no stigma associated with ceasing a repurchase program at times when there is no free cash flow to deploy or if attractive investment opportunities emerge in the future.  In contrast, cutting a regular dividend to make an attractive investment is almost never done because of the stigma associated with such a move.

Despite the advantages, share repurchases can be pursued for sub-optimal or even nefarious purposes.  Executives can use share repurchases to temporarily prop up the stock price by acting as a means of “support” – purchasing shares at times where there are few other buyers.  For executives who are compensated based on stock price movements, it can be tempting to attempt to manipulate the market for shares through repurchase activity that is not economically attractive to shareholders.  Managers can also repurchase shares in an attempt to artificially boost earnings per share since this is a common metric used to set compensation and one that is fixated upon by analysts and shareholders during quarterly earnings releases.  Executives who succumb to these poor reasons for repurchasing stock are doing a disservice to the owners of the company who they work for.

Even when executives are pursuing repurchases for all the right reasons, they could overpay for the shares if they are too optimistic regarding the company’s future prospects.  Share repurchases only add value for continuing shareholders when the price paid for the shares is below the company’s intrinsic value.  The notion of intrinsic value is necessarily subjective and managers are going to tend to be naturally optimistic regarding the prospects for the business they run.  This can lead to repurchases at times of elevated stock prices which will destroy value for ongoing shareholders.  If the value destruction is severe enough, shareholders would have been better off receiving cash dividends and paying the income taxes.

Share repurchases have also been subject to various political stigmas over the years, many of which have been reported in the financial media particularly since the corporate tax cut went into effect this year.  The one time effect of the corporate tax law change with respect to repatriation of cash long held in foreign countries and the recurring effect of the lower tax rate has led to concern among politicians that companies will use this cash to repurchase shares rather than reinvesting in their business.  This concern is misguided on many levels, particularly because it seems to presume that cash used for repurchases is somehow “lost” to the economy rather than reinvested in other businesses or used for consumption, both of which will have positive feedback effects in aggregate.  As stated earlier, reinvestment is not viable in cases where opportunities do not exist.  Value would be destroyed economy-wide if companies insisted on internally reinvesting capital that could be paid out to shareholders and reinvested elsewhere.

Despite the various objections to share repurchases, it is clear that buying back shares represents the most efficient means of distributing excess cash to shareholders when reinvestment opportunities do not exist and shares can be purchased at or below a conservative assessment of the company’s intrinsic value.

Berkshire’s Evolving Repurchase Program

Berkshire Hathaway has long been relatively unique among mega-cap companies because the company has not returned significant capital to shareholders and has managed to redeploy capital efficiently.  Berkshire is a conglomerate with dozens of large companies with varying levels of reinvestment opportunities relative to free cash flow generation.  Chairman Warren Buffett has been able to reallocate capital within Berkshire as a whole, taking free cash flow from cash cows like See’s Candies and directing that cash flow toward other existing subsidiaries that have reinvestment opportunities, purchasing new wholly owned subsidiaries, or investing the cash in publicly traded securities.

Warren Buffett and Vice Chairman Charlie Munger have the vast majority of their net worths invested in Berkshire and, as a result, think like owners when it comes to distributing cash to shareholders.  Reinvestment of substantially all of Berkshire’s free cash flow has eliminated personal tax consequences over the years.  The last thing Mr. Buffett presumably would want to do is declare large cash dividends and subject all shareholders, most notably himself, to the resulting massive tax consequences.  While he clearly prefers to reinvest cash flow within Berkshire, it also seems obvious that he would prefer to repurchase shares if faced with a situation where Berkshire cannot redeploy cash internally.

Berkshire first introduced a share repurchase program in 2011 that limited management to repurchasing shares only when they traded at or below 110 percent of book value.  The program was later amended to allow repurchases at or below 120 percent of book value to facilitate the repurchase of a large block of shares from the estate of a longtime shareholder.  However, repurchases in the open market have not taken place in any meaningful quantities because most observers have presumed that the repurchase limit of 120 percent of book value represents a floor or a “Buffett Put”.  Although this perception is likely not accurate, it has kept Berkshire shares stubbornly above the level at which management is permitted to repurchase shares.

Berkshire’s recent amendment to the program allows for share repurchases without specifying a particular limit relative to book value.  The repurchase of shares must only be at a level where both Mr. Buffett and Mr. Munger believe is below intrinsic value and the repurchase cannot reduce Berkshire’s overall cash holdings below $20 billion.  No repurchases will take place at least until Berkshire’s second quarter results are released in early August.

Flexibility Adds Value

Berkshire shareholders have often considered how long cash could be successfully redeployed internally.  Indeed, looking forward a number of years, it is difficult to see how the massive free cash flow the company is likely to generate can be deployed internally or through acquisitions.  Up to this week’s announcement, it appeared likely that Berkshire would eventually have to return cash primarily through cash dividends because the shares rarely trade below the level where repurchases would be allowed.  However, the amended plan makes it far more likely that excess cash will be returned via repurchases.  This development means that the “risk” of significant tax consequences for Berkshire shareholders in the coming years is reduced.  It seems reasonable to expect cash dividends from Berkshire only at times when the share price is clearly trading above intrinsic value.

From the perspective of a longtime Berkshire Hathaway shareholder, the news is very welcome primarily because tax consequences would be significant in the event of cash dividends and there is no recourse to avoid those dividends other than selling highly appreciated shares which also would incur significant tax consequences.  Berkshire’s amended program increases the probability that the company will continue serving as a means of compounding wealth with minimal tax consequences for years to come.  Longtime shareholders benefit from the “float” represented by their personal deferred tax liability.  As long as they avoid selling shares, the deferred tax liability “works” on their behalf and continues compounding.  The beauty of being able to compound wealth using not only your capital but deferred tax liabilities cannot be overstated.

The amendment to the plan also increases the flexibility of Berkshire’s future CEOs to return capital via repurchases without being second guessed constantly. If Mr. Buffett had left the 120 percent of book value limitation in place until his death or retirement, the next CEO would have faced tough questions if he wished to relax or eliminate the restriction.  Now that Mr. Buffett has eliminated the restriction himself, the next CEO will be more free to return capital through repurchases than he otherwise would have been.  With Mr. Buffett approaching his 88th birthday next month, he is clearly positioning the company to act in an optimal manner beyond his tenure.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.

Book Review: Early Bird – The Power of Investing Young

“Compound interest is the 8th wonder of the world.  He who understands it earns it.  He who doesn’t pays it.”

— Attributed to Albert Einstein

The quote above has often been attributed to Albert Einstein although there is some controversy regarding whether he ever actually made this statement.  However, regardless of the historical accuracy of the quote, it is undeniable that a solid understanding of compound interest is a requirement for basic financial literacy.  Exponential functions like compound interest are not automatically intuitive for most people, especially when interest rates are microscopic, as they have been in recent years.  Yet the principle is relatively simple and should be a requirement for high school graduation.

Relatively few young people have a natural inclination to plan ahead, a tendency that our consumer oriented culture does nothing to discourage.  Without a solid understanding of the power of savings and compound interest, there is no counter-balance to the natural impulse to prefer consumption right now to potentially greater consumption at some point far in the future.  An understanding of compounding can be thought of as a partial immunization to falling into destructive spending habits.  Early Bird: The Power of Investing Young is a new book intended to introduce young people to the exciting world of investing.  Maya Peterson is only fifteen years old and started investing at the age of nine with $100 raised from the sale of her American Girl dolls.  As Maya says “Teenagers, more than anyone, should be educated in this field.  Why?  Because they have the power of time!”

The book is primarily intended to encourage young people to harness the power of time to create investing “snowballs” – a term associated with Warren Buffett’s life story of starting with small amounts of capital and watching it snowball into tens of billions of dollars.  A refreshing aspect of the book is that Maya understands that buying a stock is more than simply buying a virtual “piece of paper” with quotes that squiggle around every day.  She clearly understands that ownership of stocks is simply a proxy for ownership of the underlying business.  Furthermore, she seems to like the process:  “The world gives you clues and an investor is like a detective who has an endless series of mysteries to try and solve.”  This is precisely the task of an intelligent investor.  Investors take the accumulated worldly wisdom they have obtained in life and apply that to the analysis of companies within their individual circles of competence, and then make judgments regarding the relative attractiveness of businesses they can understand.

One of the best ways to get young people interested in investing is obviously to focus on companies that they personally are familiar with and understand.  All teenagers are familiar with companies such as Disney, Coca Cola, Starbucks, Amazon, McDonalds, Wal-Mart and many more.  Maya advocates something along the lines of the classic “Peter Lynch” approach of buying what you personally know, with the caveat of digging into the fundamentals.  The book covers some basic financial concepts and primarily relies on the use of tools such as The Motley Fool and Morningstar websites rather than going directly to the SEC filings.  This seems understandable especially for younger investors, but teenagers approaching the end of high school who are serious about investing should begin to delve into primary sources such as SEC filings in addition to information services like Morningstar.

The book also contains interesting interviews with established professional investors as well as individual investors with many years of experience.  This is important because the life experience of a fifteen year old author is inevitably going to be limited.  By going to individuals with many decades of experience, Maya gives the reader a sense of the process serious investors go through when selecting specific investments.  She also spends some time discussing socially responsible investing, a topic likely to resonate with idealistic young people who wish to invest their money only with companies that share their values.

Although only a certain percentage of young people are going to be interested enough in business to delve into the details required to make investments in specific companies, all teenagers could greatly benefit from the fundamentals presented in this book.  There is nothing wrong with investing money passively in broad based index funds over a long period of time.  Although stock valuations are quite high today, someone just starting has the advantage of time and should view any temporary declines as buying opportunities since they have the majority of their life (and earnings potential) ahead of them.

Perhaps the best way to help a young person start to invest is to fund a Roth IRA account when they begin earning their own money.  Most teenagers are unlikely to want to plow all of their earnings into investments but suppose that a teenager earns $5,000 over the course of a year in part time jobs.  If the teen can be persuaded to save perhaps half of this amount, or $2,500, his or her parents could match that amount and invest a total of $5,000 in a Roth IRA account.  Roth IRAs are ideal for those who have many decades ahead of them.  If a fifteen year old invests $5,000 this year and achieves a real compounded return of 5 percent, that $5,000 will grow into purchasing power of over $57,000 in 2018 dollars by age 65 in fifty years, and no taxes will be owed when these funds are withdrawn in retirement.

Early Bird is an impressive achievement and would make a good gift for a young person who is interested in investing.

Disclosure:  The Rational Walk received a review copy of the book.  

Tax The Small Investor Behind The Tree

“Don’t tax you, don’t tax me, tax that fellow behind the tree!”

— Senator Russell B. Long

“No one should see how laws or sausages are made. To retain respect for sausages and laws, one must not watch them in the making. The making of laws like the making of sausages, is not a pretty sight.”

— Source uncertain but often attributed to Otto von Bismarck

As much as value focused investors might prefer to be reading annual reports and conducting other fundamental research, it has been difficult in recent months to ignore the various permutations of “tax reform” that have been taking shape in Washington.  Even Warren Buffett, someone who is known for his aversion to political distractions, has admitted that tax reform is a big factor in his decision making this year.

After failing to repeal and replace the Affordable Care Act, Republican politicians are desperate to deliver on at least some of their campaign promises.  The House of Representatives has already passed tax reform legislation and the Senate is very close to voting on their own tax package.  Assuming passage of a tax bill in the Senate, the House and Senate will enter reconciliation discussions before attempting to pass a final bill that the President will sign into law.  The goal is for legislation to be signed into law by the end of the year.

While there are many aspects of tax reform that will have major impacts on business conditions and the investment climate, one specific proposal has made its way into Senate legislation that appears to specifically target individual investors.  The change has to do with how investors calculate the cost basis of shares at the time shares are sold.  Currently, investors are able to specify the specific shares that are being sold which makes it possible to minimize capital gains taxes when part of a position is being sold.  Under the Senate proposal, investors would have to dispose of shares on a “first-in-first-out”, or FIFO, basis.

Obscure Accounting –> Real Life Impacts

This change might seem technical and obscure but it has powerful real impacts on small investors who have steadily purchased shares of companies over long periods of time.  In contrast, it has virtually no impact on traders who turn over their portfolios several times per year.

Let’s take a look at a hypothetical example that demonstrates the real life impact of the Senate’s proposal on a small investor.  James is a 65 year old pharmacist who plans to retire on January 1, 2018.  Over the past twenty years, James has invested in Berkshire Hathaway B shares on the first trading day of each year.  He started in 1998 with a $10,000 investment that purchased 327 Berkshire Hathaway B shares (split adjusted – assume for this example that purchasing fractional pre-split shares would have been possible).  Every year, he increased his investment by approximately 3 percent which roughly mirrored increases in his paycheck.  Today he owns 3,962 shares of Berkshire Class B worth slightly more than $717,000.  Of this amount, over $448,000 represents capital gains.  The exhibit below illustrates the annual purchases and the capital gain attributed to each purchase:

So the time has come for James to retire and he plans to draw down his portfolio of Berkshire shares at a rate of 4 percent per year to fund part of his retirement expenses.  This drawdown will start on the first trading day of 2018 and will involve a sale of 158 shares.  If Berkshire’s class B shares are trading at around today’s level of $181 at the beginning of 2018, the sale of 158 shares will result in proceeds of roughly $28,600.  (For purposes of this discussion, we will ignore commissions which are so low these days as to be nearly immaterial).

James has always expected to pay capital gains taxes when he started selling shares in retirement.  However, his accumulation of shares over the years was based on the understanding that he would be able to select the specific shares that were being sold.  Under current law prevailing in 2017, he would select the entire 2017 lot of 107 shares as well as 51 shares out of the 2015 lot of shares.  Here is what the capital gain would be under current law:

  • 2017 Lot:  107 shares sold at $181 (basis: $163.83) for proceeds of $19,367 with a gain of $1,837.
  • 2015 Lot:  51 shares sold at $181 (basis: $149.17) for proceeds of $9,231 with a gain of $1,623.
  • Total Proceeds:  158 shares sold at $181 for proceeds of $28,598.
  • Total Capital Gain:  $3,460

Under the Senate proposal, James would not have the ability to specify the shares that he is selling.  The assumption would be that the 158 shares being sold are from his first tax lot, that is, the shares that he purchased back at the beginning of 1998.  So, under the proposed law, here is what the capital gain would look like:

  • 1998 Lot:  158 shares sold at $181 (basis: $30.58) for proceeds of $28,598 with a gain of $23,766.

Assuming that James is in the 25 percent tax bracket for ordinary income, he would pay Federal capital gains taxes at the 15 percent rate:

  • Federal tax due under current law:  0.15 x 3,460 = $519
  • Federal tax due under proposed law:  0.15 x 23,766 = $3,565

Granted, it is true that James may benefit from other aspects of the tax reform legislation that could blunt the impact of this increase in capital gains taxes, but it would take a significant offset elsewhere to recover from a ~$3,000 capital gains tax hike due to the Senate’s tax proposal.  On capital gains, at least, James feels somewhat like Charlie Brown when Lucy pulls away the football.  His careful strategy of accumulating shares over two decades and intent to liquidate the highest cost basis shares first has been thwarted by an obscure provision motivated primarily by Senators desperately trying to get the bill to “score” more favorably.  The change is intended to raise revenue.  When Fidelity, Vanguard and other mutual fund firms objected, the Senators answered the phone and exempted fund companies.  Will they even answer a call from James?

Broader Effects

The impact on individual investors facing near term tax hikes should be clear but there are also broader effects that may or may not have been discussed by the politicians.  One clear impact will involve estate planning.  Shares that are left to heirs receive a “step-up” in cost basis coinciding with the date of death.  In other words, when James passes away, his low cost basis shares will “step up” to the current stock price so that his heirs will only owe capital gains taxes on further appreciation.  By being forced to liquidate lower cost basis shares, James will be less able to pass on low cost basis shares to his heirs.

The proposed change will also impact investors still in their accumulating years.  Let’s say that James is not retiring next year but in ten years.  Will he still want to put new savings each year into Berkshire Class B shares knowing that these specific shares cannot be “sold” under all of the lower cost basis shares in his portfolio are disposed of?  Effectively, recent lots of stock are “trapped” in the sense that they can only be liquidated after all of the earlier shares are sold.  James might well decide to put his funds into another company instead knowing that he can liquidate those shares at a relatively high cost basis, if desired.  Some might say he should be diversifying anyway, but isn’t that a decision that should be made based on the merits of investment choices and an individual’s personal view of the best place to invest his or her funds?

Any tax policy that causes investors to depart from acting based on fundamentals is bound to cause inefficiency in allocation of capital.  At the micro level, as with James, this has no discernible macroeconomic impact.  But when millions of potentially suboptimal tax driven decisions are aggregated, it could well have an impact on how capital is allocated economy-wide.

Tax reform was supposed to simplify the overall system, raise the funds necessary to run the government, and allow decision making to be based on business merits rather than playing tax games.  While there is always going to be a certain amount of lobbying and sausage making in Washington, it is disappointing that a supposedly “pro-business” party has presided over reform proposals that not only fail to achieve the stated objectives but might actually further distort economic incentives and decision making.

UPDATE:  The final tax legislation passed by Congress in late December 2017 did not include the FIFO changes discussed in this article.  However, it is quite possible that this provision could be included in future tax law changes now that it has been brought up as a revenue raising idea.

Book Review: University of Berkshire Hathaway

“It can’t possibly be this easy!”

A first time attendee of a Berkshire Hathaway annual meeting might find it hard to believe that there could be any skeptics in the crowd.  In contrast to the boring, useless, and perfunctory meetings held by nearly all publicly traded companies, Berkshire’s annual meeting resembles a combination of a carnival and shopping mall.  Tens of thousands of admiring fans of Warren Buffett and Charlie Munger flock to Omaha every spring to shop, socialize, and listen to words of wisdom.  However, after attending several meetings over the past eighteen years, I can confirm that there are indeed some skeptics and the most common criticism of the Buffett and Munger investing system is that  “It can’t possibly be this easy!”

Daniel Pecaut and Corey Wrenn run an Iowa based investment firm and have been regular attendees of Berkshire Hathaway annual meetings for over thirty years.  Their meeting notes form the raw material for their recent book, University of Berkshire Hathaway.  Over the past three decades, Berkshire’s meetings have grown from approximately 500 attendees to over 40,000 and the events have become much more elaborate and carnival-like.  However, the core message delivered by Warren Buffett and Charlie Munger has never really changed.  While it is true that the types of businesses Berkshire has purchased have changed dramatically, most notably tilting toward capital intensive businesses in recent years, the underlying desire to purchase excellent businesses at fair prices has never wavered.  The Berkshire Hathaway investment approach can be characterized as “simple”, at least on the surface, but in the world of finance, doing what is “simple” is not always “easy”.  There are institutional biases that clearly favor doing what is complex over what is apparently simple.

Physics Envy

Traditional curriculum in finance has long been based on the notion of market efficiency.  This supposed efficiency renders nearly all attempts to outperform the market to be akin to tilting at windmills.  And there is an element of truth in this claim.  Most markets are probably “efficient” most of the time.  The error is extrapolating “most of the time” to “all the time”.

The underlying assumption of market efficiency does make it possible to represent markets with equations that are seemingly as precise as formulas representing natural phenomena in physics.  Business and investing could now be a “real science” and professors in the field could be accorded the respect that comes along with scientific recognition.  The most famous formula in academic finance is probably the capital asset pricing model, but, of course, there are many other more specialized formulas such as the Black Scholes Model for pricing options.

These academic models, by providing apparent scientific precision in a field of social science, introduce a certain level of complexity and a requirement that market participants demonstrate a minimum level of numeracy.  No one would deny the need for a physicist to have a certain fluency in higher mathematics but, in the field of investing, Warren Buffett has long asserted that nothing more than basic mathematics is required.  If that is the case, much of the progress in the field of finance over the past half century was a waste of time.  And it is actually worse than that:  many academic models have been colossal failures in practice and the consequence has been blow-ups in the real economy.

The Buffett/Munger System

So what is the Buffett and Munger approach?  Attendees of Berkshire Hathaway annual meetings know that the leaders of the company constantly harp on topics such as understanding a company’s moat, evaluating the skills of the managers running the business, ensuring that one does not pay silly prices, and perhaps above all, insisting on a high degree of integrity.  It is true that relatively arcane topics related to accounting sometimes come up, but typically these sermons have to do with accounting rules that distort actual business results – in other words, complexity that detracts from the fundamental simplicity of investing.

But “simple” doesn’t necessarily mean “easy”.  Not by a long shot.  The judgment required to understand a business and make an evaluation of intrinsic value can take years to develop.  As Charlie Munger has emphasized for decades, one must obtain a certain amount of “worldly wisdom” in a variety of fields.  Through a multi-disciplinary approach of lifelong learning, anyone with a reasonably high IQ (think 120 rather than 180) should be able to accumulate a working understanding of enough “mental models” to be ready to strike when opportunity presents itself.  The concepts are simple but obtaining the worldly wisdom requires years and decades of sustained effort.  And the sustained effort and concentration required to obtain worldly wisdom is anything but “easy” for most people to accomplish in the age of Twitter and other distractions.

The Annual Meetings

The next best thing to attending a Berkshire Hathaway meeting (or, more recently, viewing the webcast) is to read accounts of the meetings which have become increasingly available over the years.  Prior to purchasing my first shares of Berkshire Hathaway in 2000, I read and re-read Lawrence Cunningham’s compilation of Warren Buffett’s letters to shareholders.  This compilation has since been updated to include all letters through 2015.  Much of what is covered at annual meetings is also discussed in annual letters to shareholders and this collection provides tremendous insight into the Berkshire system.  Mr. Cunningham’s compilation is arranged by topics rather than years so one can read all of Mr. Buffett’s thoughts on mergers and acquisitions, for example, spanning several years.  This is very useful, although reading the letters chronologically (available for free at Berkshire’s website) is also very useful.

Mr. Pecaut and Mr. Wrenn chose to present their meeting notes on a year-by-year basis which provides a contemporaneous account of the annual meetings.  Their book is not a transcript of the Berkshire meetings but rather a set of curated notes that highlight the topics that they found most interesting.  The notes tend to be longer for the later meetings which is probably mostly because the length of the annual meetings increased from two and a half hours in 1986 to well over five hours in recent years.  They made a point to present the notes as a historical record, that is, mostly unaltered from when they took the notes and sent them to their clients.  This is valuable because the commentary is not impacted by hindsight bias.  For example, Mr. Buffett’s glowing account of David Sokol in the early 2000s remains intact despite Mr. Sokol’s fall from grace in 2011. Similarly, many of Mr. Buffett’s comments on macroeconomic factors, particularly inflation, proved to be incorrect but those notes are left intact.  No one is infallible and the contemporaneous account of these judgments, later proven to be in error, highlight the wisdom of Mr. Buffett’s admonition to avoid investing based on macroeconomic factors.

While readers mostly benefit from the fact that the authors do not alter their notes based on subsequent information, it might have been valuable to include a small commentary after each year to note material subsequent developments.  One of the problems with the book is that it is difficult to read all of the notes on specific topics (such as inflation) because there is no index.  One must go year by year and rely on taking notes to consolidate comments on specific topics.  Perhaps this is not a problem for those who read books electronically, but it can be a little frustrating for those of us who still read physical books.  All books of this type should really feature a complete index.

Despite the small shortcomings, anyone interested in Berkshire Hathaway will find this book interesting.  Serious students of Warren Buffett and Charlie Munger will certainly want to also read the annual letters, either chronologically or through Mr. Cunningham’s compilation (or, better yet, both!).

Certain shareholders used to take pride in how cheaply one could travel to Omaha and attend the Berkshire Hathaway annual meeting.  Back in 2000, it was possible to stay downtown at non-outrageous prices, car rentals were reasonable, and it was common to walk in off the street and get a table for dinner at an Old Market restaurant after the meeting. Back then, “tuition” including airfare, lodging and meals could often be had for well under $500.

Today, the cost of attending Berkshire Hathaway meetings has become prohibitive because the 40,000+ attendees overwhelm the small city’s capacity.  For the past two years, Berkshire has webcast the annual meeting (a step we advocated back in 2010) with little impact on the number of attendees.  The annual meeting is still worth attending in person at least once to see the carnival atmosphere and, for some, to shop at a discount.  The rest of us can obtain a university class education in business simply by streaming the meeting over the internet.  As of the date of this article, the 2017 meeting livestream is still available.  Watch the webcast online for free and then buy ten or more B shares with the savings.

Disclosures:  The Rational Walk LLC received a review copy of the book.  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.

Book Review: The Man Who Sold America

“The settling of the country, the machine age, the coming of the automobile, telephone, movies, radio, the advances in fine arts and all the sciences, demanded that our capacity to accept and use new ideas be developed to a point never before seen on the pages of history.”

— Albert Lasker

The twentieth century was characterized by massive technological changes that impacted the course of human history in ways that would make the world of 2000 nearly unrecognizable to individuals living a century before.  Most people living today view consistent advances in standard of living to be the norm.  However, the steady advance of living standards is really a story of the past two centuries.  The family of 1800 shared much in common with the way of life of their ancestors in 1700 and 1600.  But by the early 20th century, per capita GDP had more than quadrupled from levels seen in the early 19th century.  Cynics of the early 1900s who thought that living standards had finally plateaued were quite mistaken.  Progress dramatically accelerated.  From 1913 to 2008, per-capita GDP increased nearly six-fold.

As Steve Jobs famously observed, people often do not know what they want until you show it to them.  When brand new products are introduced, consumers do not automatically line up to make purchases because the underlying need has yet to be established.  Whether the novel product is a disposable handkerchief in the 1920s, a refrigerator in the 1930s, or the iPhone in 2007, consumers need a compelling reason to part with substantial amounts of their hard earned cash.  They need a “reason why” the product should be purchased.  What does the product do for them that they previously had not conceived of?  How will it become an indispensable part of their lives?  Advertising, whether in print, over the airwaves, or on the internet, must provide a coherent storyline that consumers can embrace.  Few people in the 1950s would question the need for a refrigerator just as few today would question the need for a smartphone.  Advertising was the spark that created the initial demand.

The Advertising Century

The story of Albert D. Lasker, as told in The Man Who Sold America, is synonymous with the story of how advertising transformed the American economy during the first half of the 20th century.  Constant technological progress was a given for Lasker who was born in 1880 and grew up in booming Galveston at a time when the city was the center of trade in Texas and rivaled New Orleans as one of the nation’s largest ports.  Lasker showed streaks of entrepreneurialism as a child.  However, his passion was not in advertising but in journalism and by the age of sixteen, he was already scoring scoops and writing for the local newspaper.  Although Lasker said that “every urge in me was to be a reporter”, his father did not approve of the “drunkenness and debauchery” then common among reporters.  Lasker’s father called in a favor with Daniel Lord, one of the principals of Lord & Thomas, and Lasker soon moved to Chicago to embark on his career in advertising at the young age of 18.

Being forced into a career choice by one’s parents typically does not turn out well but Lasker’s case was an exception.  He found that he not only was exceptionally good at sales but enjoyed the work and rapidly advanced within the firm.  This was fortuitous because shortly after Lasker married in 1902, his wife contracted typhoid fever and became permanently disabled.  Facing very large medical bills, Lasker gave up any remaining dreams of switching to journalism:  “From then on, I had to concentrate on work, and from then on, I knew I was fooling myself that I would ever get out of advertising.”  By early 1904, Lasker was considering striking out on his own after achieving notable success marketing products such as Van Camp’s canned pork and beans.  At the insistence of Frank Van Camp, Lasker was made a one-quarter partner in Lord & Thomas on February 1, 1904 at the age of 23.  Following the death of Ambrose Thomas in 1906, Lasker became the leader and half owner of Lord & Thomas and by 1912 he had achieved full control of the firm which he would control for the next three decades.

Readers with an interest in advertising and marketing will find the story of Lasker’s leadership of Lord & Thomas to be particularly fascinating.  Lasker went on to pioneer many advertising techniques including “reason why” advertising and figuring out ways to measure the effectiveness of individual advertisements.  Advertising had been largely unscientific and it was difficult to measure the impact of spending by clients.  There’s an old joke that half of advertising spending is wasted but the problem is that no one knows which half.  Lasker used mail order advertisements to test and validate various approaches.  He would run variations of print advertisements and test the response rate of different variations, and then concentrate resources on those techniques that had proven effective.  This might sound familiar to those who have employed “A/B testing” in contexts such as web sites.  Lasker’s notable achievements include inventing the Sunkist and Sun-Maid brands, broaching the sensitive topic of how to market sanitary napkins with the Kotex brand, dramatically improving the performance of products such as Palmolive soap and Pepsodent toothpaste, and perhaps more controversially, expanding the appeal of Lucky Strike cigarettes to women.  Lasker, who died in 1952, is the man most responsible for transforming the advertising industry and ushering in a century of ever increasing demand for consumer products.

Advertising Today

Albert Lasker did not live to see the dawning of the Information Age and the amazing consumer products that have surfaced over the past several decades.  What can we learn from his life and legacy that might be relevant to today’s world?

It might be tempting to say that the world is so different today that few of Lasker’s insights and contributions are relevant, but this would be a hasty conclusion. “Reason why” advertising is just as relevant today as it was a century ago.  Perhaps the most salient example involves a product that no one viewed as essential a decade ago:  the smart phone.  Sure, cell phones were common during the 1990s and were viewed as important tools, but today smart phones might as well be permanent appendages for a majority of people in wealthy countries.

What changed?

The iPhone, much ridiculed by certain competitors, featured a virtual keyboard and was, quite simply, a fully featured computer that fit in one’s pocket.  Lacking the rigid physical alphanumeric keyboard featured on competing products, the iPhone could transform itself from a mere telephone to a web browser and innumerable other applications, none of which were considered “essential” by consumers prior to the product’s introduction in 2007.  But the product was initially met with much skepticism.  It took a marketing genius to convince the public that the product had mass appeal.  Steve Jobs may or may not have been inspired by Albert Lasker but he understood “reason why” advertising.  He did not respond to the current demands of consumers.  He created new demand for an entirely new product by explaining the benefits of the product and showing how it would be an indispensable part of our lives.

Mass media is still the driving force behind most advertising, although highly personalized advertising is now possible online and is being fully exploited by companies such as Facebook and Google.  Mass market advertising in print, television and radio still bears much resemblance to advertising from many decades ago and adheres to the same underlying principles pioneered by Albert Lasker.  It seems highly probable that mass market advertising will always exist in one form or another, but it is also undeniable that personalizing advertising has enormous advantages that will be fully exploited in the decades to come.  It is enormously valuable to know who one is speaking to in an advertisement.  One cannot know that when presenting a print ad in a newspaper or broadcasting an advertisement on traditional television.  One can know exactly who the target is when advertising online and on smart televisions connected to the internet.

Are traditional advertising agencies obsolete today?  To what extent are companies like Google and Facebook “disruptors” to traditional advertising?  The need to communicate information to potential consumers has not gone away by any means.  Indeed, the competitive landscape is just as challenging today as it has ever been, if not more so.  So the need to formulate compelling messages to entice consumers to purchase products has not gone away, and it seems very unlikely that this need will ever go away.  The internet in general and personalized advertising in particular are important changes to the industry that have the potential to make advertising much more targeted and effective.  However, the creative skills that were brought to bear during the early days of advertising are still relevant today, and probably more so because good personalized advertising is more difficult to accomplish effectively, not easier.

When radio was first appearing as a new platform for advertising, Albert Lasker was initially skeptical but eventually came to embrace it once it had been proven to be effective.  Radio and television were massive changes for the advertising industry but what remained constant is the fact that most messages were intended for the mass market.  What is different about the internet is the potential for more targeting but ultimately the internet is simply another platform.  The core competency of major platforms like Google and Facebook does not appear to involve the creative side of advertising.  Coming up with effective messages will always be in demand and the major players in the industry have embraced this reality organically and through acquisition of specialized digital marketing firms.

The advertising industry has consolidated rapidly over the past few decades and is now dominated by a small number of large players such as WPP, Omnicom, Publicis, and Interpublic.  These large firms are essentially holding companies for smaller individual agencies that have been acquired over many years.  Client turnover in the industry is relatively low and most companies do not change advertising agencies frequently.  Advertising firms with longstanding client relationships do not typically require tangible equity to operate, have negative working capital requirements, and throw off significant free cash flow.  However, market participants have lately expressed skepticism regarding the long term durability of these business models.  While it remains to be seen whether these fears are realized, value investors might do well to examine the advertising industry carefully.

Individuals associated with The Rational Walk LLC own shares of Omnicom.

Note to readers:

I have received a number of inquiries recently regarding The Rational Walk’s presence on “social media”, especially Twitter.  Not participating on social media in recent months has been a conscious decision made after much consideration of the amount of “noise” on social media.  The “noise” vastly overwhelms any “signal”, and this was just as true for The Rational Walk’s Twitter content as for most other accounts.  The value of posting or reading social media is very limited.  Even worse, by looking at social media multiple times per day, one engages in “context switching” that is toxic to concentration and development of deeper fluency in any subject.  For readers who are on social media, links to any future articles will appear on Twitter, Facebook, and LinkedIn but any other activity will be very rare.

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