The Rational Walk
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Markel Corporation at $800/share June 18, 2015

MKLLogoMarkel Corporation is a financial holding company engaged in the specialty insurance and reinsurance markets as well as in a growing number of industrial and service businesses that operate outside the insurance marketplace.  Markel seeks to actively invest its shareholder equity and insurance float in a combination of common stocks and fixed income investments in order to achieve higher returns than would be possible in a traditional fixed income portfolio.

In many ways, Markel has attempted to emulate the model long embraced by Berkshire Hathaway in which an insurance business provides low or no-cost “float” representing safe leverage for shareholders.  Many companies seek to be “mini-Berkshires” but Markel has perhaps come the closest in terms of matching rhetoric with reality and producing long term returns demonstrating the wisdom of their approach.  Although round share price numbers alone are not meaningful as indicators of value, breaching $800 per share is a milestone for Markel and as good a time as any to examine whether the shares might still represent a reasonable value.

Overview

Although Markel’s management has been open regarding its emulation of Berkshire Hathaway’s business model, the company is at a much earlier stage of its diversification into non-insurance subsidiaries and still must be evaluated primarily as an insurance company.  Markel offers three distinct sources of value.  First and most significantly, the company has a longstanding record of generating underwriting profits in several niche markets in the property/casualty insurance industry.  The insurance business was greatly expanded with the 2013 acquisition of Alterra and now includes a significant reinsurance business.  Second, Markel has a long history of investing shareholders equity and insurance float in a portfolio containing both common stocks and fixed income securities.   Thomas S. Gayner, Markel’s President and Chief Investment Officer, has a long demonstrated ability to run an equity portfolio earning returns in excess of the S&P 500.  Third, over the past decade, Markel has been building its Markel Ventures group of manufacturing and service businesses operating outside the insurance sector.  This is very much in line with Berkshire Hathaway’s business model but is still a relatively small source of value relative to insurance and investments.

Insurance Underwriting

Markel, in its current configuration, must still be evaluated first-and-foremost as a property-casualty insurer.  The effectiveness with which the company conducts its insurance business can easily overwhelm the results of the investing and non-insurance sectors.  The universal rule when evaluating an insurance company is to ascertain whether management has a demonstrated track record of discipline when it comes to setting appropriate rates for coverage and is willing to walk away from customers rather than underwrite policies at prices likely to lead to underwriting losses.  Since nearly all insurance managers will say the right things when it comes to underwriting discipline, one must ignore the rhetoric and look at the results over long periods of time.

The combined ratio of an insurance company measures underwriting performance.  The ratio compares incurred losses, loss adjustment expenses and underwriting, acquisition and insurance expenses to earned premiums.  If the combined ratio is less than 100 percent, the company has an underwriting profit.  If the ratio is over 100 percent, the company has an underwriting loss.  In today’s low interest rate environment, any insurance company that is not at least at break-even (combined ratio of 100) is unlikely to offer shareholders a reasonable return on equity.  The figure below shows Markel’s combined ratio since 1999:

Markel's Combined Ratio

As we can see, Markel has posted satisfactory combined ratios in most years, with the ratio falling under 100 percent in eight of the past ten years.  What this means is that the company is generating float that represents cost free leverage that can be profitably employed in the company’s investment operations.  Furthermore, the company’s underwriting performance has stacked up well historically against the industry as a whole as we can see from the figure below which appears in Markel’s 2014 annual report:

MKLCRvsIndustry

A full evaluation of Markel would need to delve deeper into the insurance operations than we have in this article.  Markel currently divides its insurance business into three segments:  U.S. Insurance, International Insurance, and Reinsurance and the company’s historical financial statements traditionally used different segmentation prior to the Alterra merger.  Furthermore, Markel’s 2013 acquisition of Alterra greatly increased the size of the insurance business and introduced the reinsurance business into the mix.  One cannot necessarily look at Markel’s fifteen year underwriting record and assume that these results will replicate in the future with the current book of business.  However, Markel’s management has taken steps to conservatively reserve for the business inherited from Alterra and initial results have been positive over the past two years.  The important point to take away from this brief overview of Markel’s insurance operations is that current management has a demonstrated track record of generating low or no cost float for deployment in the company’s investment operations.

Investment Portfolio

Markel has an investment portfolio of $18.6 billion (including cash equivalents) while shareholders’ equity stands at $7.9 billion as of March 31.  This substantial investment leverage is primarily made possible due to Markel’s historically cost free float as well as a modest amount of traditional debt.  Markel shareholders effectively have $1,330 of investments working on their behalf even though book value per share is only $564.

Of course, even cheap or cost free leverage can be a double edged sword when it comes to its effect on equity if investment results are poor.  So even if Markel’s insurance managers continue to do a great job generating combined ratios well under 100 percent, shareholders might not benefit from this cheap leverage unless the company’s investment management delivers attractive returns.  As a result, one must examine the historical track record of Markel’s investment operations and formulate an opinion on how well the investments are likely to perform in the future.

Markel’s investment portfolio was comprised of the following asset classes as of March 31, 2015:

Investment Allocation

As of December 31, 2014, the fixed maturity portfolio had a relatively short 4.2 year duration and an average rating of AA.  Due to the Alterra acquisition, Markel inherited a sizable fixed income portfolio. Management has been slowly allocating additional funds to the equity portfolio since the merger although this process has no doubt been hindered by relatively high valuations in the general stock market.  Over time, it is not unreasonable to expect that Markel’s investment allocation will tilt further toward equity securities and away from fixed income investments, particularly if the interest rate environment remains unfavorable.  Nevertheless, Markel will always have to maintain a very significant fixed income portfolio that will probably roughly approximate the level of float generated by the insurance business.

Although Markel’s equity portfolio contained 106 stocks as of March 31, 2015, it is heavily concentrated with the top twelve positions accounting for over fifty percent of the value of the overall portfolio.  Berkshire Hathaway is currently the largest equity position followed by CarMax, Walgreens Boots Alliance, Brookfield Asset Management, and Walt Disney.  Diageo, Marriott, Home Depot, Wal-Mart, and Deere round out the top ten.  For a full listing of Markel’s equity holdings, please refer to Dataroma’s analysis of the portfolio.

Although much analysis could be conducted on each of Markel’s top ten equity investments, for our purposes in this article, we will just examine the end results over the past ten years as measured against the S&P 500 index:

Investment Results

Investors seriously considering Markel might want to go back even further than ten years but the conclusion will be the same:  Markel has a demonstrated record of achieving excellent equity returns relative to the S&P 500 index.  This has been demonstrated through multiple market cycles over a very long period of time.  Tom Gayner is only 53 years old and anyone who has heard him speak about Markel knows that he clearly enjoys his job and is unlikely to leave.  It is unclear whether he has developed an investment team capable of producing outsized equity returns so succession is always a concern but the chances are good that Mr. Gayner will remain in charge of the equity portfolio at Markel for a decade or longer.

As we noted earlier, low cost or cost free float is only valuable in the hands of investment managers with a demonstrated track record of performance.  Markel has a demonstrated ability to generate cost free float and to deploy it intelligently over long periods of time.

Markel Ventures

Berkshire Hathaway shareholders have benefited greatly over the decades due to the fact that Warren Buffett is willing to invest the company’s capital in both wholly owned subsidiaries and in marketable securities depending on conditions prevailing in the market.  At certain times, it has been possible to purchase small pieces of a business (common stock) at prices far below what it would cost to acquire the entire business in a negotiated transaction.  At other times, an entire business might become available at a price that is more attractive than the common stock of comparable businesses.  Mr. Buffett’s approach allows the ultimate flexibility and increases the chances of profitably deploying capital in various market conditions.

Several years ago, Markel created a wholly owned subsidiary called Markel Ventures.  Today Markel owns interests in various industrial and service businesses that operate outside the insurance industry.  Much like Berkshire’s model, these businesses have management teams responsible for day to day management of operations while capital allocation and other strategic decisions are determined collaboratively between subsidiary management and Mr. Gayner.  According to the latest annual report, Markel seeks to “invest in profitable companies, with honest and talented management, that exhibit reinvestment opportunities and capital discipline, at reasonable prices” and the company intends “to own the businesses acquired for a long period of time.”  All of this should sound familiar to Berkshire Hathaway shareholders.

Markel does not consider Markel Ventures to be a reportable segment but the company’s financial reporting has slowly increased the amount of detail provided about this collection of businesses.  A consolidated balance sheet and income statement was provided in the 2014 annual report pertaining to the Ventures business.  The income statement is replicated below:

MKLVenturesIncomestatement

A complete review of Markel Ventures and an assessment of individual business units is beyond the scope of this article, but it would not take long for a reader to review the information provided by Markel in the latest annual report.  It is quite clear that management has big plans for Ventures and that the importance of this sector has increased quite a bit in recent years.  We choose to mostly disregard Ventures when assessing Markel’s current value and view the operations as providing additional upside potential in the future – perhaps significant upside potential.  In other words, it might be best to demand Markel Ventures for “free”, meaning that one could demand sufficient value from the insurance and investment operations to justify the price paid for the stock without giving consideration to the additional value potential of Ventures.

Is Markel Worth $800/share?

Insurance companies are typically evaluated based on the stock price relative to book value.  The fair value of an average insurer with a mediocre underwriting track record and a conventional fixed income portfolio would probably be less than or equal to book value particularly in the current interest rate environment.  So at a superficial level, Markel does not appear to be particularly cheap with the stock price exceeding $800 per share and book value of $564 as of March 31, 2015.  A price-to-book ratio of 1.42 would be quite generous for a typical insurer.  But is Markel typical?

It is quite clear that Markel has a demonstrated ability to produce underwriting profits over long periods of time and to perform more strongly than the typical insurer.  Furthermore, Markel has an investment record that is far better than what one might expect from an insurer restricted to a traditional fixed income portfolio.  This has not been lost on market participants in the past as we can see from the chart below:

Markel Price History

We can see from a visual examination of the chart that the market has almost always assigned a price-to-book ratio in excess of 1.0 to Markel.  The main exceptions were during the depths of the financial crisis and in mid to late 2011 when even Berkshire Hathaway briefly traded near book value.  We can see that the strong price movement in Markel stock over the past several years has been accompanied by strong book value per share growth but the market has slowly been willing to assign a more generous price-to-book ratio especially over the past year.

Does this mean that Markel’s price-to-book ratio is too high?

A longer term view would indicate that the market regularly assigned a more generous price-to-book ratio prior to the financial crisis as illustrated by the following chart:

MKL P/B Ratio

If viewed in this larger context, one may regard the return to a price-to-book ratio in the 1.5 range to be the bottom of Markel’s typical valuation range prior to the financial crisis.  Prior to 2008, Markel typically traded in a P/B range of 1.5 to 2.0 or higher rather than the 1.0 to 1.5 range that has prevailed since the crisis.

Regardless of the price-to-book ratio’s movements over time, what we really care about is whether buying or holding Markel stock at $800 is likely to yield acceptable investment returns over time.  One cannot reasonably make an informed decision on the attractiveness of a stock simply by looking at one easily calculated number.

The following valuation model attempts to look at Markel’s valuation primarily in the context of the power of its investment portfolio to drive up book value per share.  For this exercise, which is by its nature relatively imprecise, we make assumptions regarding the likely returns for Markel’s overall investment portfolio (cash, fixed income, and equities) over the next five years and estimate how these returns will impact book value.  We assume that the insurance business provides a combined ratio of 100 percent (underwriting break-even) over the period and assign no value to Markel Ventures.  Based on these inputs, we attempt to estimate shareholders’ equity five years from now.  A future market capitalization is estimated based on using a range of possible price-to-book ratios that might prevail in five years.  Finally, we use a discount rate to estimate the present value of the market capitalization.  We assume a constant share count to arrive at a current intrinsic value per share.

Markel Valuation Model

Taking the base case as an example, we assume that Markel can compound the investment portfolio at a rate of 5 percent over the next five years and that the terminal price-to-book ratio will be 1.5.  Under those assumptions, we can expect the market capitalization of Markel five years from now to be approximately $18.9 billion.  If we demand a 10 percent annualized rate of return to own Markel shares, we could then pay up to $840 today and achieve that required return.  If we pay the current price of $805, the implied rate of return would be closer to 11 percent.

If one takes the conservative scenario, Markel would only compound the investment portfolio at a 3.5 percent compounded rate and the terminal price-to-book ratio would be 1.25.  Under such conditions, someone demanding a 10 percent annualized rate of return should only pay up to $608 for the shares today.  Another way of looking at it is that someone using these assumptions would have to settle for a 4 percent return if paying $805 for the shares today.

Clearly there are many ways of looking at Markel’s valuation and the model illustrated above is just one example.  However, it does seem like Markel is not particularly overvalued at $800 per share and could be worth substantially more if the market assigns a higher price-to-book ratio and Mr. Gayner can compound the investment portfolio more rapidly than the base case assumes.  Furthermore, if the insurance business operates at an underwriting profit and Markel Ventures begins to provide more material results, there could be additional upside.

On balance, Markel’s stock price exceeding $800 doesn’t appear to be irrationally exuberant.  However, whether the shares offer an attractive proposition for investors today depends on the variables used to estimate the company’s future success as well as the margin of safety the investor demands when making a new commitment.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Markel Corporation.

 

A Return to Simplicity June 16, 2015

Thirty years ago, Back to the Future was released at movie theaters throughout the United States.  Starting Michael J. Fox, the summer science fiction blockbuster portrayed fantastic concepts such as time travel while the sequel released a few years later depicted amazing technology that would be available in the seemingly distant future of 2015.  While flying automobiles capable of time travel have yet to appear in suburbia, our lives are in fact full of electronics providing access to information that would have been unthinkable in the 1980s.

With technological marvels available at the fingertips of nearly everyone in rich countries, someone back in 1985 might have expected that individuals in “knowledge based” industries would be more productive than ever by 2015.  Surely the flood of information and stimulus would cause people to get much more done in less time and have far more time to spend with their families and devote to recreational pursuits!

Those Were the Days …

The sarcasm might be obvious to a contemporary reader but perhaps surprising to someone suddenly transported from 1985 to 2015.  Let’s say that the time traveler is an individual investor who enjoys spending several evenings per week and most Saturdays researching securities.  How would the investor have gone about this activity in 1985?  He would most likely be an avid reader of the Wall Street Journal and Barron’s, both of which would arrive in paper form at his doorstep.  Being an early riser, the investor would sometimes have to wait until the paper was delivered at 8am on Saturday to begin reading Barron’s.  It would sometimes be difficult to get through the newspapers before getting to the library exactly at opening time at 10am in order to be first in line to peruse the latest Value Line Investment Survey which, of course, would also be in paper form.

If a specific security sparked an interest, our enterprising investor would need to obtain SEC filings. The nascent EDGAR system began collecting data in 1984 but practical considerations would have probably led our investor to wait until Monday morning to contact his full service broker in order to have a paper copy of the SEC filings sent to him via the US Postal Service.  With some luck, the filings might arrive by the end of the week in time to review the following Saturday.  After reviewing the SEC filings, perhaps the next step of the research process would be to look for newspaper reports concerning the company in question over the previous five years.  Luckily microfiche could provide that information assuming that the library, which was under constant budget pressure, maintained subscriptions to the relevant publications.  Hopefully the microfiche reader would be available, as it normally would be except for when the local high school students monopolized it for term paper research.

Information Nirvana!

Having been transported to 2015, our fictional investor would be jumping head over heels with delight once he realizes that access to information is available at his fingertips on multiple tiny devices as well as desktop computers with unimaginably sharp displays.  There is no longer any need to wait for physical copies of anything in order to research investments.  One need not physically move at all in order to review the library’s online Value Line Investment Survey and nearly all accumulated human knowledge is available at low or no cost on the internet.

Surely our investor will now be so much more productive that he will either be able to research the same number of investments in a tiny fraction of the time or vastly increase the number of investment possibilities to consider!  So much more time on weekends will be available for golf, tennis, and time with the family!

The Dark Side

Equipped with a modern computer with a large high resolution screen, the latest iPad and iPhone and even the new Apple Watch, our investor settles into his home office on Saturday morning to research investment opportunities.  As before, he starts by reviewing the Wall Street Journal and Barron’s, but this time on his iPad rather than on paper and he can start at 6am rather than 8am!  However, while reviewing a Barron’s feature story, our investor is somewhat startled to see a message notification on the iPad informing him that his boss has just sent an urgent email regarding a change that must be made to a presentation scheduled for Monday afternoon.

In the world of 2015, our surprised investor learns that professionals are usually expected to be available to the boss on nights and weekends (and sometimes 24/7), as facilitated by email and text messages.  Still, the presentation is nothing major to worry about and can be dealt with at the office on Monday morning or perhaps on Sunday evening. Back to Barron’s!  But suddenly there’s a weird buzzing sensation on his wrist – an urgent notification from the CNBC app on his Apple Watch!  One of his current companies just announced that the CFO has resigned to pursue “various personal interests” effective immediately.  That can’t be good!  It must be investigated immediately!  Soon the phone is buzzing with text messages, more haptic feedback is triggered by the watch, and distractions keep coming all morning … by mid afternoon, the interesting company our investor started reading about shortly after 6am seems like a distant and unimportant memory and, of course, has not been pursued at all.

Less Can Be More

One need not be a Luddite to recognize the often pernicious impact of immediate access to all sorts of information in our daily lives.  We are flooded with stimulus that encourages us to never focus entirely on one activity, whether in our professional or personal lives.  Despite much scientific research indicating that multi-tasking can not only be harmful from a cognitive perspective but actually result in less work getting done, our competitive instincts lead us to brag about being able to “walk and chew gum at the same time”.  Appearing to not be “multi-task capable” can be a career limiting in many organizations despite the evidence that focus leads to better results.

The views expressed here are hardly groundbreaking and many experts have recognized the harmful cognitive effects of distractions and information overload.  Specific to the internet, there are now a variety of tools available to strip out the actual content from websites to allow a reader to focus on the content rather than the formatting or the ancillary noise such as advertisements, excessive graphics and animations.

But why should tools be required to make a typical website user friendly for single-tasking users who wish to devote all of their attention to the content at hand?  Many websites have economic models that require placement of numerous advertisements in many locations.  Very few websites can charge anything for content so advertising is often the only revenue generating possibility.  However, some sites have adopted needlessly noisy and complicated formats for no reason other than seeking to appear “modern” or to emulate other sites.

This seems rather pointless.

If advertisements and complexity are not required for a site’s economic model, they should simply be eliminated.  Accordingly, The Rational Walk has adopted a much simpler format that will hopefully be more readable for users who want to focus on the content.  The only “advertisements” that now exist on The Rational Walk are links to books on Amazon.com which appear within book reviews and other articles.  This should be relatively unobtrusive for most readers.

Dilbert-Multitasking

 

How to Read the Berkshire Hathaway Annual Report February 27, 2015

Berkshire Hathaway Mill - New Bedford, MAThe release of Warren Buffett’s annual letter to shareholders is one of the most important events of the year for value investors.  This year, the significance of the letter is accentuated by the fact that fifty years have passed since Mr. Buffett took control of Berkshire Hathaway. Mr. Buffett is effectively the “founder” of Berkshire in its current form as an investment holding company and conglomerate of operating subsidiaries.

Berkshire Hathaway’s annual report, scheduled to be released tomorrow morning, has long followed a format leading off with a table documenting Berkshire’s annual and cumulative performance followed by Mr. Buffett’s letter to investors and Berkshire’s financial results for the past year.  This year, Mr. Buffett’s letter is expected to focus on his view of Berkshire’s potential evolution over the next fifty years.  In addition, Charlie Munger has written a separate letter to shareholders outlining his view of Berkshire’s next fifty years.  According to recent interviews, there has been no collaboration between Mr. Buffett and Mr. Munger when it comes to presenting their thoughts on Berkshire’s future.

Form Your Own Opinion

From the moment the report is posted online at 8 am eastern time tomorrow, social media and news outlets will be flooded with various opinions regarding the annual letter and Berkshire’s results.  Sometimes one has to wonder how it is possible for anyone to form instant opinions but it is a virtual certainty that at 8:01 am, declarative judgments of the contents of the material will already be prevalent online.  To immunize yourself against this intellectual assault, simply print the annual report on actual paper, turn off your computer, and disconnect from all social media and news until after finishing a review of the report.  Failure to do so will inevitably pollute your own judgment regarding the contents of the report and, even worse, may do so in a subliminal manner as the opinions of others act in subtle ways to alter your own thinking.

First Things First

As a general rule, it is best to review the actual results of a business prior to reading management’s assessment of the results.  In most cases, the reason behind doing so is to avoid being unduly influenced by management teams (or more frequently PR consultants) who are trying to spin results in some way.  With Berkshire Hathaway, we do not have to worry about Mr. Buffett trying to mislead shareholders but if we read his letter prior to reading about Berkshire’s results, we will invariably be influenced by his conclusions anyway.  Since it will be very difficult to read the entire financial report before peeking at Mr. Buffett’s letter, at least resolve to conduct a thirty minute review of Berkshire’s important business segments and overall financials before delving into the letter.

What to Look For in the Letter

Mr. Buffett’s letters typically follow a format where he presents his overview of Berkshire’s recent results and follows up with essays on various topics.  Sometimes the topics are directly relevant to Berkshire’s business units but often they also involve much broader topics.  It is likely that the letter will, to some degree, follow the format of prior years but we can perhaps expect a more lengthy review of how Berkshire’s fifty year record came about since this forms the foundation of what Berkshire is today.  Once that foundation is well understood, we can look to the future and we can expect Mr. Buffett’s views on how Berkshire might evolve over the next fifty years.

There are a number of key topical areas that shareholders should look for:

Management Succession

There is no reason to believe that Mr. Buffett has changed his mind regarding continuing to lead Berkshire Hathaway as long as he is fit to do so and recent television interviews provide no reason to suspect any deterioration in his physical or mental condition.  However, as the recent passing of Berkshire Hathaway Director Donald R. Keough at age 88 reminds us, the health of a man in his eighties can often change for the worse very quickly.  Berkshire’s succession plan may not be needed for another ten or twenty years or it could be needed in the near future.

Mr. Buffett is nearly certain to not name the current frontrunner to be Berkshire’s next CEO but he could very well expand upon his thoughts regarding the necessary qualities and characteristics that will be needed.  At this point, there are a number of Berkshire executives who are often named as potential future CEOs but, as time passes, many of these men are getting into their 60s or 70s.  Mr. Buffett might drop clues regarding the desired duration of his successor’s tenure.  He has previously hinted that the next CEO should have a long tenure and, if this is reinforced, one might tend to believe that the top candidate could be in his 50s rather than in his 60s or 70s.

Capital Allocation

Mr. Buffett’s prior letters have often gone into great detail regarding his views on the role of a CEO as capital allocator.  This will be one of the most important roles for the next CEO in addition to maintaining Berkshire’s unique corporate culture.  A key decision that the next CEO will face will involve whether to return capital to shareholders or to continue Mr. Buffett’s practice of retaining all earnings.

Shareholders who might otherwise agitate for a return of capital have long been content to allow Mr. Buffett to retain all earnings since having a large amount of cash on hand provides him with a great deal of optionality when it comes to future deals.  Given Mr. Buffett’s long demonstrated mastery of the art of capital allocation, having long periods of near-zero returns on a pile of cash is viewed as an acceptable trade-off to preserve the optionality of a major deal that would be facilitated by the cash.  No matter how accomplished Mr. Buffett’s successor will be, shareholders are unlikely to have the same patience.  Some words of wisdom regarding how much flexibility Mr. Buffett’s successor should have in this regard might be useful.

It will be virtually impossible for Mr. Buffett to paint a picture of Berkshire in fifty years without at least implicitly rendering a verdict on Berkshire’s ability to continually deploy cash internally at attractive rates of return.  If Berkshire retains all earnings for the next fifty years and is able to reinvest those earnings into attractive new subsidiaries and investments, the market capitalization of the company would be truly mind boggling.  For example, if Berkshire can compound its market capitalization at 5 percent in real terms over the next five decades, its market capitalization would exceed $4 trillion in current dollars.  At some point, Berkshire will clearly have to return capital to shareholders.  Mr. Buffett might provide clues regarding when that day is likely to arrive.

Organizational Structure

Berkshire has a reporting structure where nearly all of the major subsidiary CEOs report directly to Mr. Buffett.  This is partly due to the history behind many acquisitions and Mr. Buffett’s ability to inspire subsidiary managers to the point where they need hardly any “oversight” at all.  Berkshire’s future CEO, regardless of accomplishment, is not going to be Mr. Buffett’s equal in terms of inherent capabilities or in terms of his ability to inspire unquestioned loyalty from his subordinates.  However, it is critically important for Berkshire to retain a decentralized structure that empowers subsidiary managers.  How should this balance be achieved?  While the exact approach may be one that Berkshire’s next CEO will have to formulate, perhaps some clues will be provided in Mr. Buffett’s letter.

“What Would Warren Do?”

At some point, Berkshire’s next CEO is going to face a crisis or some event that leads shareholders and, perhaps even the Board, to start obsessing over “what Warren would do” under the same circumstances.  While it is very important to take lessons from Mr. Buffett’s life and business track record, nothing could be more harmful for Berkshire’s next CEO than to be a slave to the inferred decisions of a past leader.

Apple’s current CEO, Tim Cook, had the seemingly impossible task of taking over for an ailing Steve Jobs in 2011.  Mr. Jobs was adamant that Mr. Cook should not be haunted by constantly asking “what would Steve do?” but should simply do what he thought was right.  Obviously, it would be foolish for Tim Cook to make decisions without considering the lessons he learned from Steve Jobs, but ultimately he has to make his own decisions.  The same will be true for Mr. Buffett’s successor.  Mr. Buffett might choose to paint a picture of how Berkshire shareholders should think about evaluating the next CEO in this light.

Conclusion

The best approach for reading Berkshire’s annual report, or the annual report of any company, is to make your own judgments and avoid being influenced by others until after you have first reached your own preliminary conclusions.  On Saturday morning, the best approach is to print the report on actual paper and to go off-line to avoid even the temptation of considering the views of others prematurely.  Spend the better part of the day reading the report and considering what Mr. Buffett and Mr. Munger have to say about Berkshire’s future and then, if you choose to, engage in discussions with other Berkshire shareholders or review what the professional pundits have to say.

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

Book Review: Berkshire Beyond Buffett November 5, 2014

I love running Berkshire, and if enjoying life promotes longevity, Methuselah’s record is in jeopardy.

-Warren Buffett, Berkshire Hathaway Owner’s Manual

Berkshire Hathaway will soon reach an important milestone with the fiftieth anniversary of Warren Buffett’s control of the company.  Nearly forty percent of Mr. Buffett’s tenure at Berkshire has been accomplished as a senior citizen and he is clearly not ready to retire anytime soon.  However, Berkshire shareholders are faced with the fact that an 84 year old man has an life expectancy of approximately six years.  It is prudent to consider succession issues carefully.  Mr. Buffett has assured shareholders that the company is well prepared but how can shareholders be certain?

BerkshireBeyondBuffettWarren Buffett almost certainly has higher name recognition in the United States today than all but a small number of public figures.  Even individuals who have no background in business and investing recognize Mr. Buffett’s name but what is interesting is that he is almost always characterized as an investor rather than as a manager.  In Berkshire Beyond Buffett, George Washington University Professor Lawrence Cunningham paints a compelling portrait of Berkshire’s culture that demonstrates how Mr. Buffett’s skills as a manager have been key to the company’s growth over the past two decades.

Berkshire Hathaway’s portfolio of common stocks attracts a great deal of attention, but the bulk of the value of the company has resided in wholly owned subsidiaries for quite some time.  Mr. Buffett has assembled a diverse group of businesses over the years and has characterized his management approach as delegating “almost to the point of abdication”.  While Mr. Buffett has involved himself in operating decisions in rare cases, his primary role is to allocate free cash flow generated by the non-insurance subsidiaries as well as “float” obtained from the insurance businesses.  Berkshire’s subsidiary managers have generally proven to be very capable with many of the original family owners continuing to run businesses even with no financial need to do so.

The Economist published a skeptical article on Berkshire earlier this year questioning how Mr. Buffett will “play his last hand”.  This article is useful in that it outlines many of the concerns skeptics typically point to when it comes to succession planning.  Specifically, it is alleged that Berkshire’s business model is simply not scalable or sustainable in the absence of the man who built the company.  Would a break-up of Berkshire create more long term value for shareholders after Mr. Buffett leaves the scene?

Professor Cunningham’s book is perhaps the most comprehensive examination of this question that has been published up to this point.  The book examines the origins of today’s Berkshire Hathaway and attempts to paint a picture of how Mr. Buffett has gone about building the conglomerate seemingly “by accident”.  Whether by accident or by design, over the years, Berkshire Hathaway developed a culture that ties together seemingly unrelated business units in a manner that makes Mr. Buffett’s extreme decentralization work.  Charlie Munger likes to describe the culture very succinctly as a “seamless web of deserved trust”, and Professor Cunningham’s work provides insight into how this web has developed and can be sustained.

The core of the book investigates how Mr. Buffett has balanced autonomy and authority through the examination of several Berkshire subsidiaries.  Professor Cunningham conducted numerous interviews with subsidiary CEOs as well as shareholders so the book is based on primary research and unprecedented access.  While some of the businesses have been analyzed in depth elsewhere in the past, the book also covers smaller subsidiaries that have received less attention such as the Pampered Chef.

One of the most interesting chapters goes into detail regarding the evolution of the Marmon Group, one of Berkshire’s wholly owned subsidiaries.  Marmon is a diversified conglomerate that was built by brothers Jay and Robert Pritzker. The company was considered too unwieldy and diverse to be successfully managed after the Pritzkers left the scene, but it turns out that little changed in terms of the company’s decentralized management approach.  John D. Nichols was CEO from 2002 to 2006 and Frank Ptak has been CEO since that time.  Both CEOs spent most of their careers at ITW, a diversified conglomerate with a structure similar to Marmon.  Mr. Nichols did introduce ten division presidents to logically group together Marmon’s subsidiaries but otherwise left the units mostly unchanged.

When Mr. Buffett leaves the scene at Berkshire, it is likely that the next CEO will need to create divisions since it would be very difficult to handle over eighty direct reports.  The Marmon model might offer a potential roadmap for how this can be accomplished in a manner that does not erode the operational autonomy that Berkshire has granted to subsidiaries.

Professor Cunningham concludes his book by conceding that some “slippage” is inevitable at Berkshire:

At Berkshire after Buffett, expect slippage.  Deals may not come Berkshire’s way. Offers Berkshire makes may not be on terms as agreeable as they have been.  Negotiations may be less favorable.  Getting through the screen may be a few more subpar businesses or disappointing managers.  If the big deals do not come or the great managers do not follow, returns will be lower.  But absent some extraordinary disruption, returns will not be so disappointing as to warrant dismembering Berkshire or some other radical change.  Its design for sustainability is more powerful than that.

Indeed, Berkshire Hathaway will not be the same after Warren Buffett leaves the scene.  But that is not really the question that needs to be answered.  The question really boils down to whether Mr. Buffett’s creation is worth preserving over time.  The litmus test is not going to be evaluated based on Berkshire’s stock price in the short run but based on growth of intrinsic value over many years and decades.  Logically, intelligent capital allocation across subsidiaries can remain extremely powerful even if the capital allocator in question is not Mr. Buffett.  If subsidiaries can continue to operate well in the future without significant oversight and capital allocation between subsidiaries remains intelligent, there is no reason for the model to fail anytime soon.   Professor Cunningham’s book provides ample evidence to believe that Berkshire’s business model should outlast Warren Buffett.

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

Book Review: The Education of a Value Investor October 2, 2014

I constantly see people rise in life who are not the smartest, sometimes not even the most diligent, but they are learning machines. They go to bed every night a little wiser than they were when they got up and boy does that help, particularly when you have a long run ahead of you.

— Charlie Munger, USC School of Law Commencement, May 13, 2007

The most successful individuals in any field of human endeavor are usually those who have adopted a lifestyle of constantly seeking additional wisdom.  In many cases, this wisdom involves keeping up with new advances in fields such as medicine, engineering, or other hard sciences directly relevant to an individual’s chosen profession.  Without efforts to remain up to date, a doctor or scientist will soon find that his skills have atrophied regardless of the initial level of formal education that was attained.

Professional investors who have adopted a value based approach are certainly not exempt from the need to constantly expand their horizons.  However, once a certain baseline of knowledge specific to value investing has been attained, the main goal does not involve constantly revisiting the fundamental analytical framework but attempting to expand our circles of competence so the analytical framework can be applied to a broader set of opportunities.  Perhaps even more importantly, we must seek to know our own personality and temperament and tailor our desired circle of competence and investment approach accordingly.

The Education of a Value InvestorThe Education of a Value Investor chronicles Guy Spier’s evolution from a self described “Gordon Gekko wannabe” to a highly accomplished fund manager who has found success through a constant effort of attaining worldly wisdom and seeking to understand his own personality more fully.  The core of the book is a very personal reflection of the author’s journey and is unsparing when it comes to self criticism.  In this way, the book is more of a memoir than a road map containing specific actionable investment ideas, although several valuable insights are provided which should improve any investor’s process.

From Gekko to Buffett

Mr. Spier graduated at the top of his class in economics at Oxford University and went on to earn an MBA from Harvard.  However, despite his top notch education, Mr. Spier found himself working at D. H. Blair, an investment bank with a very problematic culture that was fundamentally at odds with how he wished to conduct his professional life.

During this difficult period, Mr. Spier became more thoroughly acquainted with value investing by reading Benjamin Graham’s The Intelligent Investor and Roger Lowenstein’s Buffett:  The Making of an American CapitalistHeavily influenced by the manner in which Mr. Buffett has conducted his life, Mr. Spier made the decision to leave D. H. Blair and eventually founded Aquamarine Fund.  Through Aquamarine, Mr. Spier has posted results far in excess of the S&P 500 and is now a very well known investor.

Most successful fund managers who write a book typically devote an introductory chapter to their history and then use the book to provide an investment framework that they have found useful over the years.  Often times, such a book is mostly a marketing document used to attract new clients.  Mr. Spier takes a radically different approach and devotes the bulk of the book to continuing a remarkably honest account of his personal journey.  The fundamental premise behind much of the book is that an investor must understand himself well enough to structure his personal and professional life in a manner that allows for success.  Additionally, there is great value in being generous with others in ways where mutually beneficial associations naturally develop over time.

A Turning Point

Perhaps the most important point in Mr. Spier’s journey was when he took the seemingly trivial step of writing a thank you note to Mohnish Pabrai after attending the annual meeting of Mr. Pabrai’s investment partnership.  This simple gesture of gratitude made without any intent of receiving something in return prompted a meaningful friendship and mutually beneficial collaboration over the years.  The most famous collaboration was when Mr. Spier and Mr. Pabrai pooled their resources to bid on Warren Buffett’s annual charity auction.  They won the auction on their second attempt and met Mr. Buffett for lunch in 2008.  Clearly, this lunch had a lasting impact on Mr. Spier and in many ways changed how he would respond to the financial crisis.

Readers will benefit from a number of insights provided in the book, particularly those related to the importance of one’s environment when it comes to investing success.  Following the lunch with Warren Buffett, Mr. Spier made the decision to leave the New York “vortex” and relocate his business and family to Switzerland.  By removing himself from an environment obsessed with short term results, Mr. Spier was able to better match his environment with his personality, thereby resulting in a setup more conducive to his brand of value investing.  Altering his environment extended well beyond simply choosing to move to a different city.  Everything from the location of his home and office to the setup of his computer monitor and the creation of a “distraction free” library where electronics are banned have contributed to a more productive environment.

This book is an account of one investor’s journey and obviously not all of Mr. Spier’s choices will match any particular reader’s personality.  The important point, however, is that we must all embark on a path of discovering the environment that best suits our own personalities and allows us to achieve the best results that we can.

Checklists and Practical Advice

Toward the end of the book, Mr. Spier shares a number of specific pieces of advice that should be helpful to many investors.  Some of the advice is hardly groundbreaking like the admonition to avoid checking stock prices constantly and avoid people who are blatantly trying to sell you something.  However, two of the suggestions are particularly thought provoking and worthy of consideration.

Meat and Vegetables Before Dessert

Mr. Spier urges investors to gather investment research in the proper order and suggests tacking the primary sources (10K, 10Q, and annual letters) before reading any secondary sources such as news articles or analyst reports.  This is important because our brains are wired to give more influence to information we read first, so it is important to read the most direct sources first.  While it is intellectually less demanding to read an analyst report or a news article than to delve into a 10K report, we should avoid reaching for dessert before consuming the basics.  While most seasoned investors would never allocate capital without reading primary sources, it is common to review news articles and other data prior to more primary sources.  Perhaps this should be avoided.

Avoid Discussing Current Investments

Many value investors are familiar with Robert Cialdini’s book Influence:  The Psychology of Persuasion due to its presence on reading lists recommended by Charlie Munger.  One of the principles discussed in the book is related to “commitment and consistency”.  When we publicly take a position on a topic, we create psychological impediments to changing our views even when facts might change in the future.  For example, if an investor recommends a stock in a speech or interview and then the facts change, it can be excruciating to have to alter one’s views to match reality.  Mr. Spier suggests that we avoid discussing current investments and provides an example of where doing so backfired for his fund.

This particular advice should be particularly relevant to any investor who also writes about his or her investments.  A good example can be taken from The Rational Walk’s series of articles on Contango Oil & Gas.  After taking a bullish stand on Contango in September 2012, we published an update in October 2012 which in retrospect appears to rationalize possible flaws in the original investment case.  By May 2013, it was increasingly clear that the outcome envisioned eight months earlier was not working out, which was discussed in a final article on the subject.  In retrospect, there is no doubt that the “commitment and consistency” principle played a role in the length of time required to overturn the investment thesis.  It is very likely that without a public discussion, this realization would have arrived much sooner (and less expensively).

Recommended for Experienced Investors

Mr. Spier has provided a great service by delivering a remarkably candid and humble book that allows investors to potentially learn from his mistakes.  It is always better to learn vicariously through the mistakes of others when possible.  However, when it comes to the psychological pitfalls of investing, a certain baseline level of personal experience is most likely required before one can profit from the experiences of others.

It would be all too easy for a novice investor to read this book and arrogantly declare that there is no way he or she would fall into the same traps.  Only when one is humbled to a certain degree through one’s own errors is it normally possible to be open to learning from the mistakes of others.  The readers who will gain the most from this book are likely to be those who have made their own share of mistakes and seek to improve themselves going forward.