Sharing Ideas? Beware of Negative Lollapalooza Effects

“Good investment ideas are rare, valuable and subject to competitive appropriation just as good product or business acquisition ideas are. Therefore we normally will not talk about our investment ideas.”

— Warren Buffett, Berkshire Hathaway Owner’s Manual

One of the interesting aspects of investing is the fact that there are so many people who are willing to discuss ideas in public forums.  As Warren Buffett points out, truly valuable investment ideas are extremely rare and discussing them in public could very well hurt an investor’s results.  As more people become aware of an attractive opportunity, it is obvious that their actions in the market will erode the price advantage and eventually eliminate it entirely.  So why do people feel compelled to go public with their ideas?

There are obviously some benefits associated with publishing investment insights, many of which we discussed several years ago.  The ability to test an investment thesis by subjecting it to the scrutiny of other intelligent investors can be quite helpful in terms of “killing an idea”, an approach advocated by Bruce Berkowitz, among many others.  Warren Buffett often turns to Charlie Munger as a sounding board for his investment ideas.  Even the best investors can benefit from seeking out the opinions of others.  The need to clarify one’s thinking to the point where it is intelligible and coherent to someone who is not familiar with a topic can be extremely valuable.  However, Warren Buffett and Charlie Munger are on the same “team”.  Mr. Buffett does not seek input by exposing his ideas to the potential competition of strangers.

There are obviously many nefarious reasons to discuss ideas as well.  An investor can build a position in a company and then write about it in a manner that is designed to increase investor interest.  The stock price might then advance allowing the promoter to cash out at a profit.  Of course, this is very common on the internet especially when it comes to thinly traded securities, but it is not an unknown phenomenon even in larger capitalization stocks.  For this article, however, we put aside the question of nefarious intent and focus only on risks facing someone discussing ideas in good faith.

Less Obvious Risks

It should be obvious that publicly discussing a company that you find attractive and are still planning to buy can only make it more expensive to purchase shares.  This is clearly true if Mr. Buffett talks about a company on CNBC but it is also true for small blogs, including The Rational Walk, especially when the company in question is small.  However, let us put aside the direct and obvious risks associated with discussing investment ideas and consider some less obvious psychological factors.

Charlie Munger has long been fascinated with the role of standard thinking errors associated with human misjudgment.  Mr. Munger’s Psychology of Human Misjudgment provides us with an extensive list of pitfalls to be aware of as we go through life.  Human beings have evolved over millennia to make many decisions based on heuristics that can be expected to work reasonably well most of the time, but pose enormous stumbling blocks in certain situations.

When we publicly discuss ideas, we should be aware of the fact that we are most certainly opening ourselves up to the negative effects of several psychological tendencies.  These tendencies work against us in many ways and, to make matters worse, we are usually unaware of the fact that we are affected.  In this article, we examine just a few of the more important psychological tendencies that could be triggered through a public discussion of investment ideas.

Inconsistency-Avoidance Tendency

For most people, the state of mind characterized by cognitive dissonance is extremely uncomfortable.  We seek to maintain consistent thoughts, beliefs, and attitudes throughout life and when circumstances occur that require us to re-examine a long-held belief, the process of re-examination is often delayed or avoided entirely.  Taking public stands on issues in a way that results in a person being identified with a particular idea pounds in that idea in one’s mind to the point where any re-examination becomes even more difficult.  The saying that “science advances one funeral at a time” is a manifestation of this tendency.

Consider what happens mentally when one publishes a write-up on a company or gives a presentation in a public setting.  The individual becomes associated with the idea to a degree that would not have been the case previously.  There is a strong desire to be proven correct, not only in terms of profiting from the investment, but also to gain approval from others.  In addition, if other investors have acted on the idea, there is a desire to not let them down even if there is no fiduciary responsibility involved.

After going public with an idea, will it be easier or harder to be open to emerging data or circumstances that conflict with the idea?  Obviously, there will be mental resistance and a tendency to interpret new developments in a way that forces consistency with the investment thesis that was presented.  This does not mean that it is impossible to reconsider the idea in light of new evidence, but a mental stumbling block has been put up that must be overcome.  There are probably many investors who can overcome this without too much difficulty.  What they are likely to have in common is full awareness of this psychological tendency and enough self confidence to be able to reassess and discard old beliefs.

Excessive Self-Regard Tendency

The field of investing tends to attract individuals who have, at a minimum, a healthy degree of self-confidence.  After all, attempting to outperform market indices that the vast majority of active investors fail to match is the same thing as making a statement that you have greater insight and skill than most other investors.  The danger, as with many other vices in life, comes when healthy self-confidence morphs into an uncontrolled ego accompanied by excessive self-regard.

Charlie Munger advises us to counter excessive self-regard by forcing ourselves to be “more objective when you are thinking about yourself, your family and friends, your property, and the value of your past and future activity.” Is it easier to be more objective when one publicly discusses investment ideas?  And isn’t the act of making a presentation regarding an investment something that is likely to pound in additional doses of self-regard, particularly when a presentation is well received?

For investors who are well known, a presentation will usually result in a reaction of the price of the investment in question, whether it is an advance due to a bullish outlook or a decline in the case of a short thesis.  Knowing that intelligent individuals (presumably) with large sums of money have acted in response to your idea can no doubt be intoxicating and will only add to an already healthy degree of self-confidence.

The flip side comes when negative information calls into question the initial idea.  Schadenfreude is probably one of the least attractive reactions when observing the misfortune of others, yet it is exceedingly common in the investment world.  Every time a high profile investor has a serious setback, social media erupts in a flurry of sarcastic commentary.  An individual with a high degree of self-regard is likely to react to such a development by lapsing into pain-avoiding psychological denial.

Social Proof Tendency

Investing can be a solitary endeavor.  The best opportunities are, almost by definition, the ones that the rest of the market has overlooked.  Irrational pessimism and short-term thinking have the power to cause market prices to detach from any reasonable assessment of intrinsic value.  When this occurs, the intelligent investor has to be willing to act quickly and forcefully to take advantage of the opportunity.  In other words, it is important to discard the notion of requiring social proof prior to acting on an investment opportunity.

The ability to go against the crowd might be obvious, but many of us are more comfortable taking action when others agree that our idea makes sense.  In order to obtain this approval, one can present ideas in a way that is designed to persuade.  The applause at the end of a presentation, positive comments on an article, or a spike in a stock price might be enough for a relatively insecure individual to redouble belief in his or her idea.  Of course, by requiring this type of approval from others, the investor has not only potentially eliminated the opportunity but also unleashed the other negative psychological forces we are discussing.

The Lollapalooza Effect

The combined effect of several psychological tendencies is not usually merely additive in nature and can behave more like an exponential function.  The tendencies discussed in this article, combined with several other tendencies discussed by Mr. Munger, have the potential to create extreme outcomes in which rational decision making is almost impossible.  The act of publicly discussing investment ideas has benefits but also poses very serious risks and this must be explicitly understood and accepted.

There is no doubt that some investors are more likely to be affected by psychological pitfalls than others.  However, to some degree, we are all subject to human misjudgment and should strive to stack the decks in our favor whenever possible.

Personal Examples

Intellectual honesty requires some degree of self examination regarding how these forces have impacted the psychology of the writer.  I will consider two separate cases where I wrote a great deal about a company on The Rational Walk and the impact the writing had on my results from an investment perspective.

Berkshire Hathaway

Over the past eight years, Berkshire Hathaway has been a frequent topic on The Rational Walk in the form of many articles and two lengthy publications.  There is no doubt that writing about Berkshire Hathaway has clarified many aspects of the company in my mind and opened up interactions with a number of Berkshire shareholders.

For the most part, my outlook for Berkshire has been proven correct over time, although obviously the journey was not at all smooth.  There were times, such as the summer of 2011, when the general premise of Berkshire being worth far in excess of book value was called into serious question.  Although it is doubtful that I would have sold shares at those levels, the public stance that I took probably had a positive effect due to the inconsistency-avoidance tendency.

About a year ago, I published an article that attempts to analyze what Berkshire might look like in 2026.  What would happen if circumstances change and Berkshire’s outlook diminishes greatly, possibly due to some problem associated with management succession?  Would I have the ability to dispassionately change my mind regarding Berkshire’s prospects in the future?  Or would I be too attached to the idea based on my public writing about the company?  The truth is that I cannot answer that question today.  I would hope that objectivity will prevail over the desire to be proven “correct” in my outlook.  But I do not know whether that is the case.  If I allow my writing on Berkshire to impact my assessment of Berkshire’s future prospects, it could prove to be a very costly mistake.

Contango Oil & Gas

A better case study of the psychological pitfalls associated with writing about ideas might be Contango Oil & Gas which I owned from 2009 to 2013.  Contango was run by a CEO who, in many ways, looked like “the Warren Buffett of oil exploration” and I wrote about the company several times starting in early 2010. However, I did not present a full write-up on the company until September 2012 when the stock price had taken a hit following an announcement that the CEO would take a medical leave of absence.

Bad news associated with the company’s operations was revealed in October 2012 but I mostly explained them away in a follow-up article.  In May 2013, the longtime CEO passed away and the company announced a merger with Crimson Exploration, which was covered in another article where I revealed that I had reversed my assessment and sold all shares.  Although I took a significant loss on the overall position, the timing of the sale was fortuitous in retrospect as shares have declined over 80 percent since then.

To what degree did writing about Contango Oil & Gas impact my financial results?  Taking public stands on Contango over the years pounded in the notion that the company was unique in the exploration and production industry, particularly in terms of the risk management approach of the company’s founder and longtime CEO.  The company was a significant percentage of my portfolio and in mid-September 2012, I purchased additional shares shortly before publishing the full write-up on September 22 (this was fully disclosed).

In October 2012, I increased my position and again wrote about Contango (again, fully disclosing the position).  I made further purchases in November 2012.  Contango, at this point, had grown into a very large position.  The company was in a volatile industry and the longtime CEO who was responsible for the differentiation of the company’s approach was on medical leave with a serious illness.  There is no doubt that writing about Contango resulted in inconsistency-avoidance.  I did not want to be wrong.

On a positive note, when the deal with Crimson was announced, I almost immediately came to the conclusion that management of the combined company would not have any of the attributes that I thought differentiated Contango’s operations and risk profile so I liquidated the entire position at a substantial loss.  I published a “mea culpa” article which was very unpleasant to think about and write.  Contango remains the largest investment mistake, in dollar terms, of my investment career.

Conclusion

There are plenty of valid reasons to discuss investment ideas in public forums or to make presentations in public.  Investors may be seeking out other opinions that can be valuable as part of their investment process.  Those who are seeking capital to manage must find a way to get the attention of potential investors.  Some people might just enjoy the interaction with other investors.  However, we must keep in mind the risks that are being taken when ideas are discussed in public.  The risks are not intuitively evident but they are very real.  We are all subject to the pitfalls associated with human psychology.  The dawning of wisdom is the realization that you too are subject to the tendencies that we might wish only affect “other people”.

The obvious policy is to only discuss investment ideas in public to the extent that doing so is expected to result in some form of net gain, whether it is monetary or intangible.  In recent years, The Rational Walk has not published as frequently as in the past and most companies under discussion have not been ones likely to result in a personal commitment of capital.  This has been mostly by design and is likely to continue in the future with the possible exception of Berkshire Hathaway.

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

Book Review: There’s Always Something to Do

“There is always something to do.  You just need to look harder, be creative and a little flexible.”

— Irving Kahn

One of the interesting aspects of the stock market involves the peculiar attitude many investors have when it comes to reacting to market advances.  If the price of groceries, gasoline, or clothing rises, most individuals are going to feel poorer rather than euphoric because each dollar will have less purchasing power than before.  The same is not true when it comes to stocks.  Investors typically are more excited about buying stocks as prices rise.  Why is this the case?  Human psychology seems to lead many of us astray.  We assume continuation of a trend and it is easy to feel “left behind” when looking at other people who are getting rich, at least on paper.  The opposite is true in market declines as investors abandon stocks due to fear of further declines even as each dollar invested is purchasing a greater ownership interest than before.

The stock market has been on a generally upward trajectory for many years and has rallied strongly since Donald Trump won the presidential election in November 2016, which incidentally was the exact opposite of market expectations at the time.  It seems like many individuals took notice when the Dow Jones Industrial Average reached the 20,000 milestone and then quickly broke through 21,000.  The Dow might be a highly flawed benchmark but it is one that people seem to follow.  Of course, a record high does not necessarily indicate overvaluation, but the recent rally has coincided with the highest Shiller PE Ratio since the dot com bubble.  The Shiller PE is based on the average inflation-adjusted earnings from the prior ten years.  As we can see from the chart below, the Shiller PE has rarely been higher than it is today:

What does this really mean?  The honest answer is that we have no way of knowing what the stock market is going to do in the short run.  As Howard Marks has pointed out, one can view investor sentiment as a “pendulum” swinging between fear and greed.  We cannot know when the pendulum has reached the furthest point and is about to swing back, but we should be able to tell when the pendulum is on the upswing toward greed.  Individual investors are again piling into stocks, Snap Inc. just went public and rallied sharply despite serious questions regarding corporate governance, and market rumors are swirling regarding potential IPOs for hot stocks such as Uber and Airbnb.

It would be arrogant and ill advised to “call” a market top, but it would be foolish to not at least note that the pendulum is firmly in an upswing.  Besides, as value investors, we should not make decisions based on market indices and instead look at individual companies.  Obviously, the market for individual companies is impacted by overall sentiment and we aren’t likely to find many companies selling below net current asset value these days.  Nevertheless, there should always be something to do for an enterprising investor.

The Story of Peter Cundill

Peter Cundill’s value investing odyssey began when he experienced a “road to Damascus” moment in late 1973 as he read Security Analysis and, like Warren Buffett and many others, was immediately struck by the power of Benjamin Graham’s logical approach.  The Cundill Value Fund, starting in 1975, established one of the strongest track records in the industry with a 15.2 percent annualized return over 33 years.

Was this excellent record due to skill or random luck?  As Warren Buffett pointed out in his classic essay, The Superinvestors of Graham and Doddsvillea certain number of investors from a large population could very well outperform over many years due to random factors.  However, the examples Mr. Buffett presented had something in common:  they were all from a “zoo in Omaha” that had been “fed the same diet”.  That is, they had operated based on the principles developed by Benjamin Graham and David Dodd starting in the 1930s.  Importantly, these investors achieved their records in very different stocks rather than piling into the same ideas.  The foundational concepts were shared by these investors but how they applied the concepts varied widely.

Peter Cundill kept a daily journal from 1963 to 2007 in which he recorded a variety of thoughts ranging from his personal life to business and investing.  Christopher Risso-Gill was a director of the Cundill Value Fund for ten years and had exclusive access to Mr. Cundill’s journals.  This positioned Mr. Risso-Gill perfectly to write There’s Always Something to Do, a book about Mr. Cundill’s life and the evolution of his investment philosophy over more than three decades.  Journals allow us to view a contemporaneous account of an individual’s life and thought process.  Mr. Cundill was diagnosed with Fragile X Syndrome, a rare and untreatable neurological condition, in 2006 and passed away in 2011.  We are fortunate that Mr. Cundill kept a detailed journal that allowed Mr. Risso-Gill to document his investment philosophy and many case studies applying his approach.

A Whiff of Bad Breath

Most arguments against insider trading appeal to our sense of fair play and ethics.  It seems dishonorable to trade based on information that is not available to others because the deck is stacked against your counterparty.  However, there are other valid reasons in favor of keeping away from inside information out of pure self interest.  By getting close to management, we can pollute our minds and compromise our reasoning process, as Mr. Cundill points out in his journal:

I will never use inside information or seek it out.  I do implicitly believe in Sir Sigmund Warburg’s adage, “All you get from inside information is a whiff of bad breath.”  In fact it is worse than that because it can actually paralyze reasoning powers; imperiling the cold detached judgement required so that the hard facts can shape decisions.  Intuition, whether positive or negative, is quite another matter.  It is a vital component of my art.  

Stock manipulations only have a limited and temporary effect on markets.  In the end it is always the economic facts and the values which are the determining factors.  Actually value in an investment is similar to character in an individual — it stands up better in adversity which it overcomes more readily.

So we should certainly avoid inside information for ethical reasons, not to mention the risk of going to prison, but also because it simply is not a great way to improve our results over long periods of time.  Our logical reasoning powers and ability to dispassionately assess facts and come to valid judgments is how we can make money investing for the long run.  The temptation to take shortcuts might always exist but should be resisted out of pure self interest.  Appealing to self interest is often a better way to achieve socially desirable outcomes compared to appealing to a sense of ethics.

When to Buy

How do we know when to purchase a security?  Do we rely on our own analysis or allow others to impact our decision making process? This can be a very important question when buying into distressed situations which, by definition, are usually hated by the vast majority of our peers:

As I proceed with this specialization into buying cheap securities I have reached two conclusions.  Firstly, very few people really do their homework properly, so now I always check for myself.  Secondly, if you have confidence in your own work, you have to take the initiative without waiting around for someone else to take the first plunge.  

Does this sound familiar?  It might to those who were actively investing in the aftermath of the 2008-09 financial crisis when pessimism was rampant and stocks had declined over fifty percent in a short period of time.  Mr. Cundill wrote the preceding words in the midst of the 1973-74 bear market which was a similar time of pessimism in the stock market.  Pessimism can be a virtue and can also lead to opportunities for investors who do their own work and have the courage to act on their convictions.

When to Sell (and associated frustrations)

Mr. Risso-Gill provides a fascinating case study of Mr. Cundill’s investment in Tiffany during the 1973-74 bear market, a time when the stock sold for less than the value of fixed assets on the balance sheet including the company’s Fifth Avenue flagship store in New York City as well as the Tiffany Diamond.  The iconic brand was effectively being given away for free so Mr. Cundill started buying the stock.  At the time, Tiffany was controlled by Walter Hoving, the company’s CEO, who clearly stated that he had no intention of ever selling his controlling stake. Mr. Cundill assured Mr. Hoving that he was “quite content to be patient and await the inevitable recognition of the fact that Tiffany shares were fundamentally undervalued.”  The two men became good friends.

After accumulating 3 percent of the company at an average cost of $8 per share, Mr. Cundill quickly declared victory and sold his entire position within a year at $19 and was able to “rub his hands contentedly.”  It appears that Mr. Cundill was content with his decision to sell because he assumed that Mr. Hoving was serious about “never selling” his controlling stake, thereby discounting the possibility that the entire company would be acquired at a control premium.  But this turned out to not be the case:

“Peter’s assessment had turned out to be entirely accurate and within a year he was able to sell his entire position at $19.00 and rub his hands contentedly.  But six months later there was a “sting” when Avon Products made an all share offer for Tiffany worth $50.00 per share and Hoving unhesitatingly accepted it.  Peter’s comment was that he ought to have asked Hoving, “Never, ever – at any price?”  

Most readers will be able to relate to the experience of selling too early.  It can really sting to sell at what we consider to be “full value” only to watch the stock price continue to ascend.  Sometimes the ascent might be for fundamental reasons that were not adequately considered.  At other times, speculative factors could come into play.  But it must especially sting when one feels misled about the intentions of a controlling shareholder and misses out on a massive control premium.  The Cundill Value Fund board members were concerned about this situation and debated the question of when to sell:

“In the end the solution turned out to be something of a compromise:  the fund would automatically sell half of any given position when it had doubled, in effect thereby writing down the cost of the remainder to zero with the fund manager then left with the full discretion as to when to sell the balance.”

Strictly speaking, this compromise is not logical.  If a manager finds a security trading at 25 percent of intrinsic value, why should he be forced to sell half of the position when it doubles in price and is still selling at 50 percent of intrinsic value?  Nevertheless, the solution is quite common among investors.  Mentally thinking of the remaining half of a position that has doubled as a “free position” has some pitfalls but could mentally make a scenario like Tiffany’s more palatable in the end.  It is somewhat refreshing to see that even an investor of Mr. Cundill’s caliber had to deal with these sorts of questions and ultimately came up with a compromise that all could live with even if it was not completely optimal.

Much later in his career, Mr. Cundill made the following observation about selling too early:

“This is a recurring problem for most value investors — that tendency to buy and to sell too early.  The virtues of patience are severely tested and you get to thinking it’s never going to work and then finally your ship comes home and you’re so relieved that you sell before it’s time.  What we ought to do is go off to Bali or some such place and sit in the sun to avoid the temptation to sell too early.”

This is reminiscent of Charlie Munger’s famous quip about “sit on your ass investing”, as discussed in Poor Charlie’s Almanack.  Sometimes we are our worst enemy when it comes to investing, and value investors can really be their own worst enemy when it comes to selling far too soon.  This is why one of the most important metrics to track each year is the result of an investor’s “do nothing portfolio” – that is, the performance of your portfolio had you done absolutely nothing all year long.  Did your trading activity add or detract value during a given year?  One way to know is to compare your results to Charlie Munger’s “sit on your ass” method of investing.

1987 Crash

It is easy to look back at any crash and fool ourselves into thinking that it was “obvious” that it would happen to those operating in the markets at the time.  Of course, this is absurd because if everyone expects a crash to occur in the future, the crash would occur immediately as everyone would sell immediately.  The same is true of post-crash bottoms.  It is never “obvious” that the market will sharply rebound.  This is why it is so valuable to keep a journal (or a blog) documenting our thoughts at the time.  For example, this article from early March 2009 on The Rational Walk makes it pretty clear that it was far from “obvious” that the market was close to a bottom.

Getting back to Mr. Cundill’s journal, we have the ability to see what he was thinking in the months leading up to the 1987 crash.  This excerpt from his journal from March 1987 documents his meeting with Jean-Francois Canton of the Caisse des Depots, the largest investment institution in Paris at the time:

“He is as bearish as I am.  He told me that Soros has gone short Japan, not something that Soros himself mentioned at our recent meeting but definitely in harmony with my instincts.  Canton and I had an excellent exchange — he understands value investment thoroughly.  As I see it, with money being recklessly printed, higher inflation and higher interest rates must be just around the corner and so much the likelihood of a real and possibly violent stock market collapse.  I have an unpleasant feeling that a tidal wave is preparing to overwhelm the financial system, so in the midst of the euphoria around I’m just planning for survival.”

How did Mr. Cundill plan for survival?  By the time the crash took place in October 1987, the Cundill Value Fund was holding over 40 percent of its assets in short term money market instruments.  Was Mr. Cundill a market timer?  Mr. Risso-Gill does not think so:

“… This positioning was not the result of a deliberate decision to build up cash because, although he had anticipated a crash, he could not have predicted its exact timing.  The enlarged cash position was actually the result of the increasing number of securities in the portfolio that had been attaining prices considerably in excess of book value, consequently qualifying them for an automatic sale unless there were overriding reasons to hold on to them.”

Due to the fact that he had ample liquidity in the days after the crash, Mr. Cundill was able to repurchase some of the positions he sold earlier in the year and the fund ended 1987 up by 13 percent.  Unfortunately, shareholders of the Cundill Value Fund redeemed shares in the wake of the crash and the fund’s capital actually declined for the year in spite of the excellent results.  Mr. Cundill was disappointed, as must be the case for any manager of an open-ended mutual fund who might wish to have permanent capital to work with.

Smart People Failing, Dictatorship, and Committees

As Warren Buffett often says, a sky high IQ is not necessary to be very successful in the field of investing.  What is required is a strong temperament coupled with the basic concepts outlined by Graham and Dodd.  Mr. Cundill makes the following observation in a journal entry on New Year’s Day 1990:

“Just as many smart people fail in the investment business as stupid ones.  Intellectually active people are particularly attracted to elegant concepts, which can have the effect of distracting them from the simpler, more fundamental, truths.”

This effect can be even worse when you get a large number of very smart people in the same room and attempt to manage by committee.  In another journal entry, Mr. Cundill reveals his views on committees versus dictatorship in the business world:

“To my knowledge there are no good records that have been built by institutions run by committee.  In almost all cases the great records are the product of individuals, perhaps working together, but always within a clearly defined framework.  Their names are on the door and they are quite visible to the investing public.  In reality outstanding records are made by dictators, hopefully benevolent, but nonetheless dictators.  And another thing, most top managers really do exchange ideas without fear or ego.  They always will.  I don’t think I’ve ever walking into an excellent investor’s office who hasn’t openly said “Yeah sure, here’s what I’m doing.” or, “What did you do about that one?  I blew it.”  We all know we aren’t always going to get it right and it’s an invaluable thing to be able to talk to others who understand.”

Warren Buffett has said that he usually learns about the actions of Todd Combs and Ted Weschler through their monthly trading reports, not by walking down the hallway at Berkshire Hathaway and interrogating his subordinates regarding their current investment moves.  Each investor is a “dictator” within the area of responsibility he has been assigned and that is how it should be.  Does this mean that no discussions take place regarding investments?  Obviously not.  Mr. Buffett’s recent purchase of Apple for the portfolio he manages for Berkshire followed the Apple investment of either Mr. Combs or Mr. Weschler.  They obviously talk about investments and mull over shared ideas, but at the end of the day, decisions are each investor’s to make and there are no committees.

Something to Do Today

As the stock market continues to levitate, we all have to figure out what actions to take, if any, in order to capitalize on opportunities and mitigate risk.  Perhaps the best approach is to emulate Charlie Munger and “sit on your ass” if you already own excellent companies and intend to own them for decades or, perhaps, even for the remainder of your life.  Or the best approach might involve selling securities as they reach or exceed prices at which any margin of safety exists.  There might even be remaining opportunities to purchase investments well below intrinsic value for those willing to look.  The answer regarding what to do today is one for each individual to answer.

Perhaps the most productive endeavor during times like this is to look for businesses that you find interesting regardless of the current valuation of the companies in question.  The key to being able to take advantage of opportunities in the future is to have a prepared mind and a list of companies that you would like to own if available at the right price.  A market crash offers few opportunities and mainly fear to those who do not have any idea what to do.  Those of us who build up an inventory of ideas far in advance of a crash are better equipped to take advantage of opportunities when they arise.  In many cases, rebounds can be as quick as a crash and those who prepare in advance might be able to capitalize.

The story of Mr. Cundill’s life and his investment track record is well worth careful study.  He is not a household name in the same way as Warren Buffett or Charlie Munger, nor does he have quite the same track record, but this is part of the attraction.  After all, there are many ways to win in the field of investing.

How to Quickly Scan a 10-K Report for Key Updates

The process that is required to get to know a company is relatively straight forward.  Every investor is going to have a slightly different approach, but good investors typically begin with primary source material such as S.E.C. filings, news releases, and the material posted on a company’s website.  Reviewing the company’s latest 10-K efficiently is extremely important.  Obviously, much more due diligence is required to come to any conclusions but the 10-K can be viewed as the foundation of the process.

Over time, an investor will be exposed to more and more businesses and may begin to follow dozens of companies either due to an actual investment or because a company is on a watch list for purchase at an appropriate price sometime in the future.  Significant work is required to “maintain” knowledge in a company over the years.  The list of reports to review can become overwhelming because most companies will post reports close to the deadline mandated by the S.E.C.  We are now close to the 10-K filing deadline for most larger companies with a December 31 fiscal year-end so the flood of incoming 10-Ks can seem a bit overwhelming.  How can we keep up?

If Everything is a Priority, Nothing is a Priority

It probably goes without saying that reports of companies that are actually in an investor’s portfolio should take precedence over companies that are on a watch list, barring some unusual circumstances.  Beyond that, we need to intelligently prioritize our reading.  To use a word common in medicine, there needs to be some type of “triage” process.  We should want to look at companies that have some significant developments taking place before looking at companies that have little that is new to report.

Let’s consider how to look at incoming 10-Ks to determine which deserve our attention first.  Berkshire Hathaway released its annual report along with Warren Buffett’s annual letter to shareholders two days ago but only filed its 10-K report this morning.  A 10-K report contains much information that is not necessarily included in an annual report.  Many Berkshire shareholders spent a good part of the weekend with the annual report and might feel like they are fully up to speed.  In the case of Berkshire, this is probably a good assumption because management is unlikely to try to “hide” something in the 10-K.  The 10-K still deserves to be read fully but should it be done right now or can it wait a few days?

Obviously, some kind of major change in the business might be reflected in the earnings press release or by management and this could determine whether to review the 10-K immediately or to put in on the back burner.  Assuming that we have already looked for the obvious newsworthy items, let’s take a look at the differences between the 2015 and 2016 10-Ks in a systematic manner.

Step 1:  Download the 10-K for 2015 and 2016

We will be using Microsoft Word to compare two versions of the 10-K.  The first step is to obtain the 10-K file from the S.E.C.’s Edgar website.  We will start by searching for all of Berkshire’s reports using the company’s ticker symbol which is “BRKA”:

After the results come up, we will filter for only 10-K reports:

We need to download the html files for the 2016 and 2015 10-K reports (published on 2/29/16 and 2/27/17, respectively) which appear in the first two rows of the table shown above.  To obtain the files, click on the Documents button next to each report and then on the first link named “Form 10-K”, as shown below in the red box for the 2016 10-K:

Clicking on the link (d303001d10k.htm) will bring up the actual 10-K report in html format.  The image below is the report as seen in a Google Chrome browser.  To save the html file to your local computer, right click on the document and select “Save As”, highlighted below in a red box:

Save the document to your local computer using a name such as BRK201610K.  Then, repeat the same process for the 2015 10-K report and save that document to your local computer using a name such as BRK201510K.

Step 2:  Compare the 10-Ks Using Microsoft Word

The next step is to take the raw html files that we have downloaded and to use Microsoft Word to compare the documents so we can scan for any changes.  Microsoft Word 2007 is the version used to generate the output shown in the screen shots, but presumably newer versions of Word have similar functionality as well.

Open Microsoft Word and click on the “Review” tab of the ribbon at the top of the application, as shown in the red box of the screen show that appears below:

Clicking on the compare button should bring up the “Compare Documents” dialog box.  Use this dialog box to specify the 2015 10-K as the “Original document” and the 2016 10-K as the “Revised document”.  There are a number of options available as comparison settings.  Our goal is not to analyze changes in the financial results as shown in various tables in the report.  That type of information is best done in Microsoft Excel after entering the relevant data, a step that is distinct from what we are doing here.  Our goal here is to spot changes in management’s explanation of the business or the risk factors.  As a result, we will uncheck the “Tables” check-box in the dialog box but keep all other default options checked:

After clicking OK, Microsoft Word will take a minute or two in order to analyze the changes to the document and present the results.  Once the results are presented, you can save the file locally to have it for future reference.

Step 3:  Scanning the Comparison Document

There will be a very large number of changes detected between the two 10-K reports and it is up to us to know what to look for as we scan through the comparison document.  Looking at each and every change is unproductive and will not save us any time compared to reading the entire 10-K from beginning to end, which is actually something that needs to be done eventually.  Remember that our goal here is only to identify major changes that might warrant our immediate attention and cause us to prioritize a review of Berkshire’s 2016 10-K over competing 10-Ks that are being posted to the S.E.C. website early this week.  In this section, we will just take a few examples illustrating the types of changes that can be spotted by running a comparison.  This is not an all encompassing analysis or an assessment of which changes are most important.

Example #1:  Business Overview

Let’s take a fairly trivial example just to get a feel for how Microsoft Word presents the changes.  The screenshot below shows the first part of the “Business” section of Part I, Item 1 of the report which is a very high level description of Berkshire (click on the image for an expanded view):

We can see that there are some minor wording changes between the two documents.  Beyond that, the interesting fact is that Berkshire’s total employment level increased from 331,000 to 367,700 during the course of 2016. For some reason, Berkshire has omitted the number of employees working at corporate headquarters from the 2016 report.

Example #2:  Clayton Homes

There are a large number of changes in the business description that are interesting, particularly related to changes in the size or scope of various business operations and, sometimes, subtle changes in wording.  One can also get a general sense of the trends in a business by looking at the descriptive text (obviously, in addition to looking at the figures in the reported financials).  For example, the exhibit below shows the section describing Clayton Homes (click on the image for a larger view):

We know that Clayton has been growing based on the data in the annual report and some of Warren Buffett’s commentary.  The comparison shows that the company now operates 38 manufacturing plants, up from 36 plants at the end of 2015.  Additionally, the network of retailers grew from 1,726 to 1,923 over the course of the year.  We can also see that the average down payment fell from 17 percent to 15 percent.

Example 3:  Risk Factors

Risk factors are often just boilerplate text supplied by a company’s legal department and it is easy for a reader’s eyes to glaze over reading this section of any 10-K.  Comparing the risk factor section for two years brings to light subtle and major changes that could warrant further study.  One of Berkshire’s risk factors involves the concentration of the company’s investment portfolio.  The text appears in the exhibit below (click on the image for a larger view):

What is interesting in this section is the addition of information regarding the change in GAAP that will change the accounting treatment of unrealized gains and losses in the investment portfolio starting in 2018.  Currently, most unrealized changes in the fair market value of Berkshire’s investment portfolio are recognized as other comprehensive income.  These changes do not impact Berkshire’s consolidated statement of earnings.  Starting in 2018, all changes in the fair value of investments will be recognized as gains or losses in Berkshire’s consolidated statement of earnings.

This change has been pending for quite some time and has been disclosed in 10-Q reports during 2016.  It represents a major reporting change because the volatility of Berkshire’s reported earnings will dramatically increase in the future.  From an economic perspective, the change is a non-event because the value of the investment portfolio has always been reflected in Berkshire’s book value.  However, the media and analysts may not grasp that reality when the volatility in Berkshire’s income statement increases starting in 2018.

Conclusion

The comparison approach described in this article can be a useful way to spot important changes in a 10-K but it definitely is no substitute for reading a report comprehensively.  It makes sense to take the time to read a 10-K once a year for a company that is in one’s portfolio or might be a serious candidate for the portfolio at the right price.  The time investment required to read a report in full is not unreasonable for a serious investor.  At the same time, we must prioritize our reading and this can be difficult to do when 10-Ks are flying into the inbox at a rapid pace.  By scanning certain sections of the 10-K for changes (principally the business description and risk sections), it is sometimes possible to spot companies that have had significant and, perhaps, unadvertised changes of a fundamental nature.  We can then prioritize these companies for review before those that have not appeared to change very much.

In the case of Berkshire, the three examples in this article are not really very significant.  They are meant only as an illustration of the type of information that can be revealed through a comparison process.  The comparison technology is not that sophisticated.  In some cases, especially in the management’s discussion and analysis, the comparison tool might consider entire paragraphs to have changed because they shifted in the order in which they are presented.  The management’s discussion and analysis section, the financial statements, and in most cases, the footnotes need to be reviewed in full.  Nevertheless, using this comparison approach can occasionally help to prioritize the order in which to review incoming reports.

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

Highlights From Warren Buffett’s 2016 Annual Letter

“Today, I would rather prep for a colonoscopy than issue Berkshire shares.”

— Warren Buffett, 2016 letter to shareholders

The last Saturday in February has become something of a ritual for Berkshire Hathaway shareholders as well as many other interested observers.  Some have likened it to “Christmas morning” for capitalists.  While this has “cult-like” overtones, the release of Warren Buffett’s annual letter to Berkshire Hathaway shareholders is rightly regarded as a major event for anyone interested in business.  This is mainly because Mr. Buffett does not restrict the scope of his commentary to Berkshire’s results but also opines on a wide variety of topics of general interest.  In a format lending itself to greater depth than a television interview, we are offered an opportunity to see Mr. Buffett reveal some of his cards.

This article presents selected excerpts and commentary on a few of the important subjects directly related to Berkshire but is not an all encompassing review of the letter, especially as it relates to commentary on general business conditions in the United States.  Everyone is going to take away something different from reading the letter and it is important to spend some time looking at the actual document before reading the opinions of others, or even reading selected excerpts.  This is particularly true for shareholders who should look at business results with fresh eyes rather than to allow others to direct them to what is important.

Read Warren Buffett’s 2016 letter to Berkshire Hathaway shareholders

Berkshire’s Intrinsic Value

Longtime observers of Berkshire Hathaway know that Mr. Buffett does not comment specifically on the company’s intrinsic value.  This is entirely appropriate for a number of reasons.  If you take two informed individuals and ask them to judge the intrinsic value of any business, it is very unlikely that the estimates will match exactly.  What we should want from a CEO is an assessment of the fundamentals.  As shareholders, we are responsible for determining our own estimates of intrinsic value.  That being said, Mr. Buffett does provide some important commentary regarding intrinsic value as well as clear indications of his view of intrinsic value relative to book value.

At the beginning of the letter, Mr. Buffett comments on how Berkshire’s book value was a reasonably close approximation for intrinsic value during the first half of his 52 year tenure.  This is because Berkshire was dominated by marketable securities that were “marked to market” on Berkshire’s balance sheet.  However, by the early 1990s, Berkshire shifted its focus to outright ownership of businesses.  The economic goodwill of acquired businesses that show poor results are required to be written down based on GAAP accounting.  In contrast, the economic goodwill of successful acquisitions are never “marked up” on the balance sheet.  This causes a growing gap between book value and intrinsic value given that most, but not all, of Berkshire’s acquisitions have turned out well:

We’ve experienced both outcomes: As is the case in marriage, business acquisitions often deliver surprises after the “I do’s.” I’ve made some dumb purchases, paying far too much for the economic goodwill of companies we acquired. That later led to goodwill write-offs and to consequent reductions in Berkshire’s book value. We’ve also had some winners among the businesses we’ve purchased – a few of the winners very big – but have not written those up by a penny.

We have no quarrel with the asymmetrical accounting that applies here. But, over time, it necessarily widens the gap between Berkshire’s intrinsic value and its book value. Today, the large –  and growing – unrecorded gains at our winners produce an intrinsic value for Berkshire’s shares that far exceeds their book value. The overage is truly huge in our property/casualty insurance business and significant also in many other operations.

What we can take away from this brief discussion is that the gap between Berkshire’s book value and intrinsic value has grown over time and, with additional successful acquisitions, should continue to grow in the future.  To be clear, important aspects of Berkshire’s results will show up in book value in the future.  Berkshire’s retained earnings are fully reflected in book value.  Additionally, changes in the value of marketable securities (with few exceptions) are also reflected in book value, net of deferred taxes.  However, to the extent that the economic goodwill of Berkshire’s wholly owned subsidiaries continue to increase, the gap between book value and intrinsic value will continue to grow.

Repurchases and Intrinsic Value

The discussion of intrinsic value, and the growing gap between book value and intrinsic value, brings up an interesting point that we have identified several times in the past.  Berkshire Hathaway has an unusual policy of declaring, in advance, the maximum price that it is willing to pay to repurchase shares.  When the repurchase program was initially created in September 2011, the limit was 110 percent of book value.  In December 2012, the limit was increased to 120 percent of book value in order to facilitate the repurchase of 9,200 Class A shares from the estate of a long-time shareholder.  The repurchase limit has remained constant ever since and Berkshire has not been able to repurchase any material number of shares despite a few occasions where the share price almost fell to 120 percent of book value.

Mr. Buffett continued to defend the repurchase limit while acknowledging that repurchasing shares has been hard to accomplish:

To date, repurchasing our shares has proved hard to do. That may well be because we have been clear in describing our repurchase policy and thereby have signaled our view that Berkshire’s intrinsic value is significantly higher than 120% of book value. If so, that’s fine. Charlie and I prefer to see Berkshire shares sell in a fairly narrow range around intrinsic value, neither wishing them to sell at an unwarranted high price – it’s no fun having owners who are disappointed with their purchases – nor one too low. Furthermore, our buying out “partners” at a discount is not a particularly gratifying way of making money. Still, market circumstances could create a situation in which repurchases would benefit both continuing and exiting shareholders. If so, we will be ready to act.

The signaling effect of Berkshire setting the repurchase limit at 120 percent of book value has clearly limited the opportunity to actually repurchase shares and has made many shareholders, including some very prominent hedge fund managers, view this level as a floor which is something we have consistently disagreed with. Mr. Buffett once again reiterates that shareholders should not misinterpret the purpose of the repurchase limit:

The authorization given me does not mean that we will “prop” our stock’s price at the 120% ratio. If that level is reached, we will instead attempt to blend a desire to make meaningful purchases at a value-creating price with a related goal of not over-influencing the market.

It is clear that Mr. Buffett regards Berkshire’s intrinsic value as far exceeding the 120 percent of book value limit and he has said so numerous times.  Interestingly, he has also given us a clue regarding what he thinks is above Berkshire’s intrinsic value:  200 percent of book value.  The following excerpt is taken from Mr. Buffett’s 2014 letter to shareholders:

If an investor’s entry point into Berkshire stock is unusually high – at a price, say, approaching double book value, which Berkshire shares have occasionally reached – it may well be many years before the investor can realize a profit. In other words, a sound investment can morph into a rash speculation if it is bought at an elevated price. Berkshire is not exempt from this truth. Purchases of Berkshire that investors make at a price modestly above the level at which the company would repurchase its shares, however, should produce gains within a reasonable period of time. Berkshire’s directors will only authorize repurchases at a price they believe to be well below intrinsic value. (In our view, that is an essential criterion for repurchases that is often ignored by other managements.)

So, there we have it:  Mr. Buffett considers 120 percent of book value, and levels modestly above it, to be likely to produce gains for buyers within a reasonable period of time (but still several years) whereas buying at a high level like 200 percent of book value could result in a very extended period of time before a profit can be realized.

As of December 31, 2016, Berkshire’s book value per Class A share was $172,108.  Class A shares closed at $255,040 on Friday, February 24.  This indicates that shares currently trade at 148 percent of book value.  This seems to be more than “modestly above” Berkshire’s repurchase limit, but well below the clear danger level of 200 percent of book.  Is 148 percent of book value a close approximation of intrinsic value?  A good level to buy shares?  Or a good level to sell?  Shareholders cannot expect to be spoon fed an answer by Mr. Buffett and must decide for themselves.

Berkshire’s 21st Century Transformation

A shareholder considering Berkshire Hathaway as an investment opportunity today faces a radically different company than what existed at the turn of the century.  As Mr. Buffett notes early in the letter, the second half of his tenure has been characterized by the growing importance of controlled operating companies.  The effect of this transformation can be clearly seen in a chart of after-tax earnings since 1999:

Sometimes, long term trends are not readily apparent to those who are observing changes on a year-to-year basis.  What is clear, however, when looking at the table above is that Berkshire is a far different company today compared to 1999.  Furthermore, this trend is likely to accelerate significantly in the future, especially if Berkshire intends to retain all or most of its earnings.  As we discussed last year, Berkshire in 2026 is going to look radically different than it does today.  However, we do not know what shape it will necessarily take, other than to note that a major recession is likely to help Berkshire substantially when it comes to capital allocation:

Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do.

What Mr. Buffett believes to be an advantage for individual investors with the right temperament is even more of an advantage for Berkshire given the company’s ability to accomplish very large transactions quickly during times of economic distress:

During such scary periods, you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted. Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively-financed American businesses will almost certainly do well.

Berkshire today has significant excess capital available for deployment but the level of exuberance in capital markets is quite high so we have seen cash continue to build up.  Mr. Buffett is 86 years old and apparently has no plans to retire anytime soon.  With some good fortune, he may still be at the helm during the next major economic downturn. From the perspective of Berkshire Hathaway shareholders, the continued retention of earnings and build up of cash makes sense primarily because we are increasing the options available to Mr. Buffett if opportunities arise during his remaining years running Berkshire.

Non-GAAP Accounting

Journalists seeking a “gotcha” story have sometimes identified Berkshire’s treatment of amortization of intangible assets as fertile ground for charges of hypocrisy.  This is because Mr. Buffett has frequently criticized the use of non-GAAP accounting measures at other companies.  In Berkshire’s presentation of the results of certain operating subsidiaries, the amortization of intangible assets is excluded and instead presented as an aggregate figure.  This appears to be done for two primary reasons:  First, the presence of intangible amortization is a function of Mr. Buffett’s capital allocation decisions rather than the underlying ability of subsidiary managers to generate returns on the actual tangible capital they are working with.  Second, much of the intangible amortization is not really an economic cost from Mr. Buffett’s perspective.  Indeed, some of the intangibles are likely to be appreciating in value over time rather than depreciating.

For several years I have told you that the income and expense data shown in this section does not
conform to GAAP. I have explained that this divergence occurs primarily because of GAAP-ordered rules regarding purchase-accounting adjustments that require the full amortization of certain intangibles over periods averaging about 19 years. In our opinion, most of those amortization “expenses” are not truly an economic cost. Our goal in diverging from GAAP in this section is to present the figures to you in a manner reflecting the way in which Charlie and I view and analyze them.

On page 54 we itemize $15.4 billion of intangibles that are yet to be amortized by annual charges to earnings. (More intangibles to be amortized will be created as we make new acquisitions.) On that page, we show that the 2016 amortization charge to GAAP earnings was $1.5 billion, up $384 million from 2015. My judgment is that about 20% of the 2016 charge is a “real” cost. Eventually amortization charges fully write off the related asset. When that happens – most often at the 15-year mark – the GAAP earnings we report will increase without any true improvement in the underlying economics of Berkshire’s business. (My gift to my successor.)

Mr. Buffett goes on to point out that, in some cases, GAAP earnings overstate economic results.  For example, depreciation in the railroad industry regularly understates the actual cost of maintenance capital expenditures required to prevent deterioration of the system.

Are the charges of hypocrisy valid?  We should want managers to present results according to GAAP (which Berkshire does within its financial statements) and to also point out important factors that might cause investors to make appropriate adjustments.  This requires both trust in management’s honesty and the ability of investors to bring to bear appropriate analytical abilities to judge the situation for themselves.  We do not have to blindly trust Mr. Buffett’s statement on intangibles.  We can see the results of the business operations over time and attempt to evaluate whether intangible amortization makes any sense in light of results.  Viewed in this manner, Berkshire’s supplemental presentation seems both useful to shareholders and reflective of economic reality.

In contrast, many companies use non-GAAP measures for purely self-serving purposes, as Mr. Buffett goes on to describe in some detail:

Too many managements – and the number seems to grow every year – are looking for any means to report, and indeed feature, “adjusted earnings” that are higher than their company’s GAAP earnings. There are many ways for practitioners to perform this legerdemain. Two of their favorites are the omission of “restructuring costs” and “stock-based compensation” as expenses.

Charlie and I want managements, in their commentary, to describe unusual items – good or bad – that affect the GAAP numbers. After all, the reason we look at these numbers of the past is to make estimates of the future. But a management that regularly attempts to wave away very real costs by highlighting “adjusted per-share earnings” makes us nervous. That’s because bad behavior is contagious: CEOs who overtly look for ways to report high numbers tend to foster a culture in which subordinates strive to be “helpful” as well. Goals like that can lead, for example, to insurers underestimating their loss reserves, a practice that has destroyed many industry participants.

Charlie and I cringe when we hear analysts talk admiringly about managements who always “make the numbers.” In truth, business is too unpredictable for the numbers always to be met. Inevitably, surprises occur. When they do, a CEO whose focus is centered on Wall Street will be tempted to make up the numbers.

Those of us who read earnings results routinely know that the types of “adjustments” Mr. Buffett refers to are more the norm than the exception.  The idea that items that recur every single quarter should be excluded from earnings is obviously absurd, but this is how managers are evaluated by the investment community.  Stock based compensation is almost always excluded from “adjusted” figures as if dilution is irrelevant (or, worse, doesn’t matter because the company is blindly repurchasing shares at any price to offset the dilution).  Many companies, including some Berkshire investees, announce restructuring activities on a routine basis and either exclude them entirely from non-GAAP numbers or report these costs as a separate corporate line item that is unallocated to business segment results.

Will Mr. Buffett’s admonishments have any effect whatsoever on the behavior of managers or the blind willingness of the analyst community to accept non-GAAP numbers at face value?  The answer is likely to be no.

Investment Portfolio

Although Mr. Buffett does not discuss Berkshire’s equity investment portfolio in much detail, there are a couple of notable items that deserve investor attention:

  • Berkshire’s investment in Kraft Heinz is accounted for by the equity method and is not carried on Berkshire’s balance sheet at market value, unlike most equity investments that are regularly marked-to-market.  As a result, Berkshire’s 325,442,152 shares of Kraft Heinz are carried by Berkshire at $15.3 billion but had a market value of $28.4 billion at the end of 2016.  This $13.1 billion in unrecorded market value is worth an incremental $8.5 billion in book value for Berkshire after accounting for deferred taxes at an approximate 35 percent tax rate.  It is probably a good idea to adjust Berkshire’s reported book value by adding this $8.5 billion.
  • Berkshire owned $7.1 billion of Apple stock at the end of 2016.  There has been much speculation regarding whether this position was purchased by Mr. Buffett or by Berkshire’s two investment managers, Todd Combs and Ted Weschler.  Mr. Buffett provides a clue:  Mr. Combs and Mr. Weschler manage a total of $21 billion for Berkshire which includes $7.6 billion of pension assets not included in the figures reported for Berkshire.  Accordingly, they control about $13.4 billion of Berkshire’s portfolio reported in the letter and annual report.  While it is not impossible that the entire Apple position can be attributed to Mr. Combs and Mr. Weschler, it would have to account for more than half of their combined portfolio.  This seems unlikely.  We would infer that Mr. Buffett is responsible for at least part of Berkshire’s position in Apple.

Are Berkshire’s positions in marketable securities “permanent”?  Many are held with no predefined “exit” date, but Berkshire reserves the right to sell any security at any time:

Sometimes the comments of shareholders or media imply that we will own certain stocks “forever.” It is true that we own some stocks that I have no intention of selling for as far as the eye can see (and we’re talking 20/20 vision). But we have made no commitment that Berkshire will hold any of its marketable securities forever.

Confusion about this point may have resulted from a too-casual reading of Economic Principle 11 on pages 110 – 111, which has been included in our annual reports since 1983. That principle covers controlled businesses, not marketable securities. This year I’ve added a final sentence to #11 to ensure that our owners understand that we regard any marketable security as available for sale, however unlikely such a sale now seems.

While it is best to not read too much into this statement, we should keep it in mind the next time media reports appear regarding Berkshire’s “permanent” ownership of stocks like Coca-Cola and Wells Fargo.  Indeed, the lack of any mention of the recent Wells Fargo scandal in Mr. Buffett’s letter coupled with this very clear statement could be viewed as a message to managers of portfolio companies.

There are many other important topics in the letter including a lengthy discourse on the merits of passive investment for the vast majority of individuals and institutions.  Readers are encouraged to review the entire letter in full and to view the excerpts and commentary in this article as only a starting point.

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

Interesting Reading – February 18, 2017

In this series, we suggest worthwhile reading material on a variety of topics of general interest.

Daily Journal Corporation Annual Meeting – February 15, 2017. Charlie Munger spoke for nearly two hours at the Daily Journal annual meeting in Los Angeles.  There are a number of unofficial transcripts available.  The notes linked to above were provided by Adam Blum via Mohnish Pabrai’s Twitter account. In addition, a good video of the event has been posted on YouTube by another attendee. The notes are a great way to get up to speed quickly but those who have a couple of hours to spare might prefer the video.  At age 93, Mr. Munger appears to be in good health and as is obviously as sharp as ever.  Topics ranged from the Daily Journal’s business operations to investments to life advice.  Mr. Munger’s only book recommendation was Edward Thorp’s A Man For All Markets which we plan to review in the near future.  Readers may also be interested in our recent analysis of Daily Journal as well as the company’s fiscal first quarter 10-Q.

Apple: The Greatest Cash Machine in History? – Musings on Markets, February 9, 2017.  Professor Aswath Damodaran updates his thoughts regarding Apple and revisits his previous valuation work.  There is a great deal that has been written on Apple since the company’s latest earnings release, much of which has focused on very short term factors such as the upcoming 10th anniversary iPhone release.  This article is different because it is an update of valuation work on the company that dates back to 2010.  Apple is increasingly attracting value investors who typically are not attracted to technology stocks.  The most notable recent example can be found in Berkshire Hathaway’s recent 13-F filing which revealed a very significant increase.  (As an aside, Prof. Damodaran has recently published a new book, Narrative and Numbers, which is on our list to read and possibly review.)

Snap’s Apple Strategy – Stratechery, February 13, 2017. Snap’s upcoming initial public offering has been widely discussed over the past few weeks.  Is the company the next Facebook, the next Twitter, or something entirely different? Ben Thompson believes that there are similarities between Apple’s historical strategy and Snap’s vision: “Not only is Snap not promising a traditional moat, it is in fact selling its humanity as a company. That the company and its Steve Jobs-admiring CEO in fact do understand users better than everyone else, that that will result in sustainable differentiation, and that the prize will be the top end of the advertising market.”  Readers may also be interested in our recent analysis of the Snap S-1 filing and Professor Damodaran’s much more rigorous valuation article.

Should You Always Keep Stocks for a Full 5 Years? – Gannon on Investing, February 15, 2017. Where do you draw the line between a “trade” and an “investment”?  Is this a matter of the amount of time an investment is held, or based on the investment thesis playing out irrespective of how long that process takes?  If we take Warren Buffett’s advice seriously, we should think of stocks as partial interests in an actual business.  Just as we would not buy a gas station and sell it a couple of months later, we probably should buy stocks with a view of holding for at least several years.  Geoff Gannon provides his thoughts on holding stocks for a minimum of five years and when it might make sense to bend that rule if a clearly superior opportunity comes up.  This link is to a twelve minute podcast but the text of the discussion is also available.

Six Sigma Buffett, Taxes, Fund Returns etc. – The Brooklyn Investor, February 14, 2017. This article attempts to analyze the level of outperformance of various famous managers and to compare the difficulty of compiling track records of various lengths.  While that analysis is interesting, a short digression on Warren Buffett’s views of the 1986 tax reform law might be even more interesting for readers who are trying to evaluate how current tax reform proposals might impact their investments or their personal finances.

Larry Cunningham on Kraft-Heinz Bid for Unilever – Latticework.com, February 18, 2017. Larry Cunningham shares his concerns regarding the Kraft-Heinz bid for Unilever and what Berkshire Hathaway’s partnership with 3G might mean for Berkshire’s culture in the long run.  Observers of Berkshire’s partnership with 3G have frequently noticed that Warren Buffett’s traditional style of acquisitions (friendly, no hostile actions, no bidding wars, leaving management in place) is almost the exact opposite of 3G’s standard procedure (sometimes unfriendly, haggling over price, significant restructuring).  So far, the partnership has worked well but perhaps not without risking Mr. Buffett’s legacy.  (Read our review of Larry Cunningham’s latest book, The Buffett Essays, covering the famous 1996 symposium with Warren Buffett and Charlie Munger).

The Happy City and our $20 Trillion Opportunity – Mr. Money Mustache, February 10, 2017. Although this is ostensibly a book review of Happy City by Charles Montgomery, it is really more of a general discussion regarding the less than optimal choices society has made over the years when it comes to infrastructure spending.  The cost of modern American style infrastructure  – wide roads, expansive parking lots, and unwalkable sprawling suburbs – is extremely high and may not provide good value for the money or result in any increase in happiness.  With talk of a massive new federal infrastructure spending initiative, perhaps this is the right time to think about whether the traditional approach is the best use of our scarce resources.

New Website:  The Spartan Spendthrift. The Spartan Spendthrift is a “sister site” of The Rational Walk which launched in January.  The Rational Walk is focused on investment commentary and security analysis for “enterprising investors” as well as those who just have an interest in thinking about business.  The Spartan Spendthrift is a site dedicated to personal finance and related lifestyle topics.  At this point, there are only a few articles on The Spartan Spendthrift but there will be more in the future.  Interested readers are invited to subscribe to the site via RSS feed, email, or following on Twitter (links are provided on the site).  The Rational Walk will also continue to have new content.  There is no set publishing schedule for either site and both are expected to remain free for readers.

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