The Rational Walk
Intelligent Investing is not a "Random Walk"

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. 

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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.

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Book Review: A Manual on Common Stock Investing March 28, 2014

“It is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately with people or it doesn’t take at all.  It’s like an inoculation.  If it doesn’t grab a person right away, I find that you can talk to him for years and show him the records, and it doesn’t make any difference.  They just don’t seem to grasp the concept, simple as it is.”

— Warren Buffett, The Superinvestors of Graham-and-Doddsville, 1984

It has been thirty years since Warren Buffett referred to value investing as an “inoculation” and his sentiment appears to be just as valid today.  The ease of access to high quality information is far greater for investors today but so is the constant noise from the hopelessly short term oriented financial media.  If a new investor is to stand a chance against the risk of becoming a speculator, he or she needs to have a firm grounding in value investing concepts and a road map for obtaining further knowledge and avoiding the noise.

A Manual on Common Stock InvestingJohn Rotonti presents beginning investors with an easily understandable guide to value investing in A Manual on Common Stock Investing.  All writers who attempt to explain investing to beginners must strike the right balance between conveying the basic principles in a manner that stresses the fact that these concepts might appear simple but are not simplistic.  Otherwise, it is all too easy for new investors to get lulled into overconfidence.  Mr. Rotonti succeeds in presenting the basic formulation required for success while stressing the need for further reading to develop an aspiring investor’s circle of competence.

The book is divided into seventeen brief chapters outlining the basic concepts a beginning investor must learn before allocating any capital.  For example, Chapter 13 covers the topic of compound interest which is one of the most powerful but least understood concepts among the general population.  It is very likely that if high school graduation required mastery of compound interest, millions of Americans would be far more prudent when it comes to savings as well as debt.  Mr. Rotonti covers this subject well using examples that should resonate with readers who were previously unfamiliar with the concept.  Since the pursuit of compounding at attractive rates of return is the driving force behind all enterprising investing, it is critical for readers to understand the massive difference in the end result of a lifetime of 10% returns compared to 7% returns.

While the book does encourage readers to pursue investing if they have a passion for the process, Mr. Rotonti urges readers who do not have the time or inclination to direct their money into index funds so they at least earn the returns offered by the overall market.  One of the most significant risks facing investors with only a passing interest in the process is that overconfidence could lead to a concentrated portfolio that performs very poorly or even results in the permanent loss of a material amount of capital.  Mr. Rotonti devotes a brief chapter to the importance of avoiding permanent losses of capital and reminds readers of the less than intuitive math required to recover from significant losses.  Diversification via broad indexing is nothing to be ashamed of for the non-enterprising investor and, over an investing lifetime, should provide attractive results while minimizing the risk of permanent losses.

Writing a book with the intent of being one of the first exposures for readers into the world of investing is not an easy task.  The balance between encouragement and caution is not necessarily easy to achieve.  Many of the concepts advocated by value investors like Warren Buffett seem so “obvious” to novices that overconfidence can quickly develop.  Mr. Rotonti provides a recommended reading list for those who would like to pursue the subject further.

After finishing this book, most readers should have a good sense of the importance of avoiding losses, the power of compounding, and the basic language and concepts used by value investors.  Based on this knowledge, the reader can determine whether to proceed with an “enterprising” strategy or opt for indexing.  We would recommend this book for beginning investors curious about whether an active role suits their interests, skills, and temperament.

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

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Book Review: Fizz — How Soda Shook Up the World December 26, 2013

Market commentators and investment managers who glibly refer to “growth” and “value” styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component — usually a plus, sometimes a minus — in the value equation.

— Warren Buffett, Berkshire Hathaway 2000 Chairman’s Letter

A common misconception regarding value investing is that the “cigar butt” approach represents the main path to success.  Such an approach can in fact yield very satisfactory results over time but, in most cases, a “cigar butt” is sold when it nears intrinsic value and must then be replaced with a new opportunity.  Most “cigar butts” are good for one additional puff rather than sustained internal compounding of value over long periods of time.

If an investor has set a high internal “hurdle rate” for compounding wealth, it is usually difficult to find a company that can internally compound intrinsic value rapidly enough.  Furthermore, companies that have already demonstrated an ability to compound intrinsic value rapidly often sell at prices that turn off almost all value investors.

Despite the difficulties involves in so-called “growth investing”, value investors should not simply “punt” when it comes to being on the lookout for companies capable of rapid compounding.  For one thing, being aware of such companies costs nothing more than reading about them and the industries involved can be quite fascinating.  Not every research prospect needs to be one that must be immediately actionable.  A bear market can quickly bring about interesting situations with “fallen angels” and turn a “growth” stock into a “value” stock overnight.

Fizz:  How Soda Shook Up the WorldOne of the more productive ways to get into a “growth” mindset is to study the history of rapidly growing industries.  In Fizz:  How Soda Shook Up the World, Tristan Donovan provides a compelling account of the soda industry from its very early days to recent controversies regarding health concerns.  Following a brief survey of the historical origins and human use of naturally occurring mineral waters, the book quickly shifts toward an account of the industry as it took shape in the late nineteenth century.

The early days of the soda industry predated the technology required to reliably and consistently bottle carbonated beverages and, as a result, nearly all soda consumption took place at soda fountains often found in the drug stores in towns and cities of all sizes.  Fortunes were made and lost during the early days with a dizzying variety of different brands and concoctions.  A technological paradigm shift took place when bottling technology progressed to the point where soda could be consumed away from the fountains and fortunes were again made and lost often due to the choices entrepreneurs made regarding whether to invest the capital required for bottling plants or to take a more capital light approach of franchising bottling rights and selling syrup to independent bottlers.

The book does not really provide much in the way of detail regarding the economics of the early industry but reveals enough to whet the appetite of readers who may wish to learn more elsewhere.  Mr. Donovan spends more time looking at higher level strategic decisions that were made to build brands over time.

Coca-Cola WWIIThe Coca-Cola Company’s decision to aggressively distribute its beverage to all troops serving overseas in World War II for five cents per serving must rank as one of the most brilliant in business history.  Five cents was the going price for a serving of soda for decades prior to the war but sugar rationing upended the economics of the industry.  Rather than seeking higher prices, Coca-Cola sacrificed profits in exchange for the prospect of saturating the military with soda that represented a small piece of America for millions of soldiers far from home.

This move likely created lifelong positive mental associations for millions of returning soldiers who then introduced their children, the baby boom generation, to Coca-Cola.  The short term financial pain of offering cheap soda to the troops paid off enormously over the decades that followed.

Coca-Cola’s experience during World War II brings to mind other aggressive promotional behavior by companies seeking to build brands.  Obviously, not all promotional efforts end up being successful over time.  Is it possible to predict which companies aggressively sacrificing profits today are doing so with a reasonable prospect of building a long term durable moat?  Or are promotional activities actually sacrificing current profits with no prospect of improvement in the future?

For example, there is much controversy today regarding due to the company’s willingness to sacrifice current profitability in order to continue dominating online commerce.  Will this promotional behavior lead to a long term moat that will allow to eventually “flip the switch” and operate for profitability or is this a never ending cycle of intense price competition?  Although online commerce has no obvious relationship to the history of soda, it is valuable to look at how a variety of competitive environments played out in the past in an attempt to understand the present and perhaps have more insight into the future.

Readers of Fizz should not expect any earth shattering revelations when it comes to thinking about investing and business but the book might help to refine some mental models regarding competitive behavior that could be useful when thinking about present day opportunities.  It is also an entertaining and quick read for anyone with an interest in American history.

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Book Review: Short Stories from the Stock Market November 1, 2013

“We don’t like trading agony for money.”

— Charlie Munger on short selling, Berkshire Hathaway 2013 annual meeting

Many long-only investors often come across companies that appear grossly overvalued by any objective standard.  In fact, in most market environments, it is quite a bit more likely to run into seemingly overvalued situations when using metrics commonly favored by value investors.  Since the number of companies within a typical investor’s circle of competence is a small subset of the overall market, it seems quite tempting to be able to act on all situations where one has a strong opinion rather than being restricted only to buying undervalued stocks.  However, long-only investors who take a naive view of short selling as merely being the “opposite” of going long will most likely quickly learn about the kind of “agony” Charlie Munger referred to at Berkshire Hathaway’s 2013 annual meeting.

Short Stories from the Stock MarketAmit Kumar, founder of Artham Capital Partners, recently published Short Stories from the Stock Market, which serves as a guide for value investors who are interested in broadening their horizons beyond a long-only strategy.  The book provides a research framework that can be used to identify actionable short ideas while avoiding situations that, on the surface, may appear to be attractive shorts but really represent a minefield.  The nature of short selling is different from buying stocks because losses are theoretically unlimited while gains are capped — the opposite of being long on a stock.  This asymmetry requires the addition of several steps to limit downside risk.

One common mistake involves shorting a stock based only on a high valuation.  Since many long-only value investors are willing to commit capital without requiring a specific catalyst, their instinct when exploring short ideas may be to assume that a ridiculously high valuation is a sufficient rationale.  In reality, a high valuation is typically a necessary condition but it is usually not sufficient.

If high valuation is not a sufficient rationale for shorting a stock, how does one go about identifying opportunities?  Ideally, a short candidate might have an unsustainable business model or be run by unethical managers who have used fraudulent methods to misrepresent the results of the business.  While correctly identifying a fraudulent company may reveal the perfect short, looking for more mundane situations like broken growth stories can also yield potential ideas.  It is common for successful long-only investors to attempt to “kill an idea”, as Bruce Berkowitz often suggests.  It is possible that a company initially researched as a long opportunity could become a short candidate if the process of “killing the company” reveals severe weaknesses.

The book provides useful case studies regarding companies that were targets of short sellers including certain examples that remain unresolved to this day.  The Herbalife example is very recent and covered well in the book.  Herbalife is particularly interesting given that very highly regarded investors have taken opposing positions on the stock.  A superficial review of Herbalife would not lead one to think that it is grossly overvalued.  The shorts do not base their thesis on valuation but instead allege that the company is essentially a fraud and have encouraged regulators to examine the company’s business practices.

Most readers would do well to listen to Charlie Munger’s advice regarding short selling.  Even in a market near record highs, there should be plenty for most investors to do on the long side particularly for those who have the flexibility to look at smaller companies.  Furthermore, it is perfectly fine to simply accumulate cash if the market is so high that opportunities are scarce.  However, for those investors who are willing to take on the challenge of short selling the rewards can be enormous assuming they understand the risks.  Short Stories from the Stock Market succeeds in its mission to provide aspiring short sellers with an intelligent framework to pursue opportunities with their eyes fully open when it comes to the risks of doing so.

Disclosure:  The Rational Walk was provided with an electronic copy of the book for review purposes.

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