Warren Buffett’s Letter to Investors – The Power of Concentration
Warren Buffett’s Berkshire Hathaway’s stock price exceeded $200,000 per share for the first time. The company is now the fifth most highly valued corporation in the world. The stock was propelled higher by record earnings that in turn were positively impacted by the sale of Graham Holdings Company (formerly The Washington Post) resulting in a gain of over 100 times the original investment. The significant ownership stake was purchased in the early 1970s. Talk about having a long-term orientation! Buffett is famously known for eschewing diversification and concentrating on a smaller number of highly concentrated investments that he understands extremely well. He has called it “deworsification” as well as the Noah’s Ark theory of investing: buy two of everything and pretty soon you have a zoo.
Buffett believes that if you have the focus, temperament, and inclination to make investment decisions then it can pay to concentrate one’s resources in a few ideas that can allow one to understand them deeply. This greatly improves the odds of knowing when they are under, over, or sufficiently valued. In his most recent letter to shareholders excerpted in Fortune Magazine he cites the example of a real estate partnership he has been in since the early 1990s related to a retail property in New York City to show the benefits of such a concentrated, long-term approach. Here is what Buffett said about his New York City investment:
“And manage it they did. As old leases expired, earnings tripled. Annual distributions now exceed 35% of our initial equity investment. Moreover, our original mortgage was refinanced in 1996 and again in 1999, moves that allowed several special distributions totaling more than 150% of what we had invested. I’ve yet to view the property.
Income from both the farm and the NYU real estate will probably increase in decades to come. Though the gains won’t be dramatic, the two investments will be solid and satisfactory holdings for my lifetime and, subsequently, for my children and grandchildren.”
Buffett goes on to cite some very important lessons learned from his investments in real estate. I suggest you read the article to find out what those are as the purpose of this post is more specific.
When the sale of The Washington Post to Jeff Bezos was announced (approximately one year ago) I was very surprised by how big the pension fund had become covering the Post employees and retirees. I kept wondering how it got so big relative to its liabilities (over $600 million of excess assets) and then the secret was revealed: A letter from Buffett to the Post’s publisher Katharine Graham in 1976 recommending how the plan’s assets should be invested. Buffett was very close to Kay Graham and loved newspapers. He took it upon himself to put his recommendations to her in writing. It was also in his best interest to do so to use his influence to help guide the company in this regard since he had become the largest shareholder. He was also far ahead of the crowd (as usual) in recognizing the potential dangers to a company using a defined benefit plan. Many companies came to find out that the liabilities grew faster than the assets.
Buffett’s letter is a classic and one that should be read by every serious investor. It conveys one of Buffett’s great strengths. Namely, the ability to think deeply and comprehensively about risks that others ignore or are unaware that they exist. That is why he was the perfect owner of insurance companies and why he was so successful with them. He has brilliantly assessed the risk/reward of long-term of insured events that if they materialized tended to happen many years after the premiums were received. This has enabled Berkshire Hathaway’s insurance companies to generate investment capital (float as it’s called in the insurance business) in which to grow the company’s assets at a rate far greater than the liabilities. The end result has been a tremendous increase in the net worth of the company, much of which had been invested over the years in a relatively small number of highly concentrated marketable securities.
The letter goes into great detail about the various ways pension plans can be designed and the pitfalls that most traditionally designed and implemented plans can fall into. Given the time when the letter was written inflation was really starting to rear its ugly head so he showed how long term promises made to employees in an inflationary environment can wreak havoc on a portfolio if the company generating the pension dollars does not have pricing power to pass on higher costs to its customers. Given that he felt that The Post had such pricing power (boy how times have changed as newspapers’ revenues have been ravaged by the internet), he then turned his focus to the various ways the pension plan assets could be managed.
Buffett doesn’t speak too kindly of the manipulative instincts of Wall Street to take advantage of the naivety and unsophistication of plan managers to sell them expensive products susceptible to poor performance. The same is said for money managers who have a difficult time outperforming various indices since they represented 70% of the market at the time and are fearful of constructing portfolios that differ so much from their peers that if they underperform they risk losing their jobs. It used to be said that “nobody ever got fired for owning IBM.” As Buffett said in the letter:
“In the short term, it frequently is better to look smart than to be smart, particularly if your employment is to be decided by a rather brief interview. If the fans are going to decide your hiring status based on only a few swings, it is prudent to develop a batting style that will remind them of Joe DiMaggio or Ted Williams, even if long-range your percentage of solid hits with that style is small and you know you obtain better results batting cross-handed.”
He then goes on to cite various statistics of uninspiring performance for a number of pension funds and concludes: “The evidence all seems to confirm that it is unwise to expect above-average investment results from a corporate pension plan, conventionally managed.” (emphasis mine) He lists various options for pension plans. These include the following:
- Parcel money out to large money managers and except under-performance.
- Replicate the indices in an early form of indexing and accept average performance less transaction costs.
- Invest only in bonds and don’t go back and forth between bonds and stocks as that’s too difficult to generate long-term success. Bonds were yielding 9% at the time.
- Find those smaller managers that have outperformed.
Regarding the latter he is skeptical that they can maintain their hot hands. He says,
“Good records of any type usually have attracted massive money flows – whether the record was based on unusual skill, luck, or even, occasionally, semi-fraudulent activity which has “manufactured” the record. Even those records which I believe to have been based at least partially on skill have wilted when subjected to torrents of money.”
As usual Buffett identified a risk far ahead of his time by citing fraud. Bernie Madoff really brought that risk to the forefront that Buffett warned about over 30 years earlier.
One of the ways CWS has tried to add value is by operating in a less crowded field than the securities market – real estate with a focus on manufactured housing from 1970 to 1990 and then a shift of emphasis to apartments from 1990 to today. Buffett makes a brilliant comparison to playing tennis when he says:
“Your win-loss percentage in tennis will not be determined by the absolute level of ability that you possess. Rather, it will be determined by your ability to select inferior opponents. If you select with care it will be quite easy to attain a winning percentage higher than, say, Cliff Richey while he is playing on the tour. Application of this principle is the key element in bridge, poker, or investments.”
So what did Buffett recommend? 15 pages into the letter he reveals his recommended approach where he says that “[i]t involves treating portfolio management decisions much like business acquisition decisions by corporate managers.” The directors had a lot of business acumen and experience with buying businesses in various industries along with terrific relationships that can be leveraged to make better decisions. He goes on to list the various negatives of owning fractional ownerships of businesses through the stock market. Namely there is a lack of control to influence the management of the company, dividend policy, less ability to borrow money since the stock would be the collateral versus the business assets, and foregoing the opportunity to sell the entire business. He does make an interesting counter-argument, however, when he writes:
“These are important negative factors but, if a group of investments are carefully chosen at a bargain price, it can minimize the impact of a single bad experience in, say, the management area, which cannot be corrected. And occasionally there is an offsetting advantage which can be of very substantial value – but for which nothing should be paid at the time of purchase. That relates to the periodic tendency of stock markets to experience excesses which cause businesses – when changing hands in small pieces through stock transactions – to sell at prices significantly above privately-determined negotiated values. At such times, holdings may be liquidated at better prices than if the whole business were owned – and, due to the impersonal nature of securities markets, no moral stigma nee be attached to dealing with such unwitting buyers.”
Buffett clearly looked for a margin of safety when recommending this strategy. At the time the pension plan had $12 million in assets. He believed it was possible and a good goal of buying pieces of businesses through stock purchases that had the equivalent of intrinsic value determined by private market valuations and transactions of $20 million and current earnings of at least $1.5 million. Obviously the dividends paid out would be worth 100 cents on the dollar while the reinvested earnings could be as well assuming the management teams have a reasonable batting average of successful capital deployment.
So how well did Buffett’s approach work? The $12 million in assets were worth over $2.0 billion in 2012 and the company did not have to make contributes for the plan for well over 20 years. It turns out that rather than managing the money itself, the company found two managers who knocked it out of the park for the next 35 years using Buffett’s recommended approach. Now that really is the power of concentration!