Lessons From Berkshire Hathaway Annual Letters (1977-1985)

Lessons From Berkshire Hathaway Annual Letters (1977-1985)

In anticipation of Berkshire’s 50th year under current management, I’m in the process of going through all of the annual letters with a fine toothed comb, and collecting what I find to be the best nuggets of wisdom. The formatting is messed up, and i'm not tech savvy enough to fix it. I hope the value of the info exceeds the price of the ugly formatting. 

Here are my favorites from 1977-1985. Enjoy!

-PhillyValueInvestor

1977 Lesson – Focus on long-term business performance, not short term price performance. 

“Most of our large stock positions are going to be held for many years and the scorecard on our investment decisions will be provided by business results over that period, and not by prices on any given day.  Just as it would be foolish to focus unduly on short-term prospects when acquiring an entire company, we think it equally unsound to become mesmerized by prospective near term earnings or recent trends in earnings when purchasing small pieces of a company; i.e., marketable common stocks.”  

Top 4 portfolio positions at the end of 1977 (cost)

GEICO 22%, Kaiser Aluminum 11%, Capital Cities 10%, Washington Post 10% 

Top 4 portfolio positions at the end of 1977 (market)

GEICO 24%, Washington Post 18%, Interrepublic 9%, Cap Cities 7% 

Top non-insurance operating businesses

See’s Candies, Blue Chip Stamps, Illinois Nat’l Bank   

1978 Lesson – No one can predict short term market fluctuations. 

“We make no attempt to predict how security markets will behave; successfully forecasting short term stock price movements is something we think neither we nor anyone else can do.”  

Top 4 portfolio positions at the end of 1978 (cost)

SAFECO, 18%, GEICO 18%, Cap Cities 15%, Kaiser Aluminum 14% 

Top 4 portfolio positions at the end of 1978 (market)

Washington Post 24%, GEICO 21%, SAFECO 15%, Interrepublic 11% 

Top 4 non-insurance operating businesses:

IL Nat’l Bank $4.2M, See’s $3.1M, Mutual S&L $3M, Blue Chip $1.4M  

1979 Lesson – Don’t buy crappy businesses just because they’re dirt cheap. 

“Your Chairman made the decision a few years ago to purchase Waumbec Mills in Manchester, New Hampshire, thereby expanding our textile commitment.  By any statistical test, the purchase price was an extraordinary bargain; we bought well below the working capital of the business and, in effect, got very substantial amounts of machinery and real estate for less than nothing.  But the purchase was a mistake.  While we labored mightily, new problems arose as fast as old problems were tamed.     

Both our operating and investment experience cause us to conclude that “turnarounds” seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price.”   

Top 4 portfolio positions at the end of 1979 (cost)

GEICO 15%, SAFECO 13%, Handy & Harman 13%, Kaiser Aluminum 11% 

Top 4 portfolio positions at the end of 1979 (market)

GEICO 20%, Washington Post 12%, Interrepublic 11%, SAFECO 11% 

Top 4 non-insurance operating businesses:

IL Nat’l Bank $5.0M, See’s $3.5M, Mutual S&L $3.2M, Blue Chip $1.6M  

1980 Lesson - Bad businesses vs good management 

“Our conclusion is that, with

few exceptions, when a management with a reputation for

brilliance tackles a business with a reputation for poor

fundamental economics, it is the reputation of the business that

remains intact.”

 Top 4 portfolio positions at the end of 1980 (cost)

General Foods 27%, GEICO 20%, SAFECO 14%, Alcoa 11% 

Top 4 portfolio positions at the end of 1980 (market)

GEICO 20%, General Foods 11%, Handy & Harman 11%, Safeco 9%  

Top 4 non-insurance operating businesses:

IL Nat’l Bank $5.0M, See’s $3.5M, Mutual S&L $3.2M, Blue Chip $1.6M  

1981 Lesson - The only 3 things that can go wrong

“We expect that undistributed earnings from such companies will produce full value (subject to tax when realized) for Berkshire and its shareholders.  If they don’t, we have made mistakes as to either: (1) the management we have elected to join; (2) the future economics of the business; or (3) the price we have paid.” 

Top 4 portfolio positions at the end of 1981 (cost)

R.J. Reynolds 22%, General Foods 19%, GEICO 13%, Handy & Harman 6% 

Top 4 portfolio positions at the end of 1981 (market)

GEICO 31%, R.J. Reynolds 13%, General Foods 10%, Washington Post 9%  

Top 4 non-insurance operating businesses:

See’s $6.3M, Blue Chip $2.1M, Wesco $1.6M, Mutual S&L $1.5M,  

1982 Lesson - The importance of purchase price 

“Our partial-ownership approach can be continued soundly only as long as portions of attractive businesses can be acquired at attractive prices.  We need a moderately-priced stock market to assist us in this endeavor.  The market, like the Lord, helps those who help themselves.  But, unlike the Lord, the market does not forgive those who know not what they do.  For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.”

Top 4 portfolio positions at the end of 1982 (cost)

R.J. Reynolds 34%, General Foods 16%, GEICO 11%, Crum & Forster 11% 

Top 4 portfolio positions at the end of 1982 (market)

GEICO 33%, R.J. Reynolds 17%, Washington Post 11%, General Foods 9% 

Top 4 non-insurance operating businesses:See’s $6.9M, Blue Chip $2.5M, Wesco $2.2M, Mutual S&L $1.5M,

1983 Lesson – Eating Your Own Cooking

“Although our form is corporate, our attitude is

partnership.  Charlie Munger and I think of our shareholders as

owner-partners, and of ourselves as managing partners.  (Because

of the size of our shareholdings we also are, for better or

worse, controlling partners.) We do not view the company itself

as the ultimate owner of our business assets but, instead, view

the company as a conduit through which our shareholders own the

assets.

In line with this owner-orientation, our directors are all

major shareholders of Berkshire Hathaway.  In the case of at

least four of the five, over 50% of family net worth is

represented by holdings of Berkshire.  We eat our own cooking.”

Top 4 portfolio positions at the end of 1983 (cost)

R.J. Reynolds 47%, General Foods 29%, GEICO 8%, Time, Inc 5% 

Top 4 portfolio positions at the end of 1983 (market)

GEICO 31%, R.J. Reynolds 26%, General Foods 18%, Wash Post 10% 

Top 4 non-insurance operating businesses:

See’s $12.2M, Buffalo News $8.8M, Wesco $3.5M, Mutual S&L $1.9M,  

1984 Lesson – On Capital Intensity 

“The first point to understand is that all earnings are not created equal.  In many businesses particularly those that have high asset/profit ratios - inflation causes some or all of the reported earnings to become ersatz.  The ersatz portion - let’s call these earnings “restricted” - cannot, if the business is to retain its economic position, be distributed as dividends.  Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength.  No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.”  

Top 4 portfolio positions at the end of 1984 (cost)

Exxon 30%, General Foods 27%, Time, Inc 15%, GEICO 8% 

Top 4 portfolio positions at the end of 1984 (market)

GEICO 31%, General Foods 18%, Exxon 14%, Wash Post 12% 

Top 4 non-insurance operating businesses:

See’s $13.4M, Buffalo News $13.3M, Nebraska Furniture Mart $5.9M, Wesco $4.8M

1985 Lesson – On Commodity industry competition

“Over the years, we had the option of making large capital expenditures in the textile operation that would have allowed us to somewhat reduce variable costs.  Each proposal to do so looked like an immediate winner.  Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable expenditures in our highly-profitable candy and newspaper businesses.      But the promised benefits from these textile investments were illusory.  Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide.  Viewed individually, each company’s capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes).  After each round of investment, all the players had more money in the game and returns remained anemic.”

Top 4 portfolio positions at the end of 1985 (cost)

Beatrice Companies 39%, ABC 20%, GEICO 17%, Time,Inc 7% 

Top 4 portfolio positions at the end of 1985 (market)

GEICO 50%, Wash Post 17%, ABC 9%, Beatrice Companies 9% 

Top 4 non-insurance operating businesses:

See’s $14.6M, Buffalo News $14.6M, Nebraska Furniture Mart $5.2M, Wesco $4.2M 

Thanks for reading Part 1. Look for a few more installments over the next couple weeks. 

Tupperware Brands, Inc. (TUP)

Tupperware Brands, Inc. (TUP)

Tupperware is a seriously wonderful business. They've generated consistently high ROIC (15%+), demonstrated smart capital allocation, and possess a simple, yet powerful business model that a ham sandwich could probably run. 

The ingenious “Tupperware Party” sales model utilizes potent psychological influences, and has proven extremely effective for a long period of time. The internet isn’t going to re-write the rules of human psychology. Read “Influence” by Cialdini for more insight into 1) reciprocity, 2) commitment, 3) social proof, and 4) liking. 

From Influence: “It’s gotten to the point now where I hate to be invited to Tupperware parties. I've got all the containers I need; and if I wanted any more, I could buy another brand cheaper in the store. But when a friend calls up, I feel like I have to go. And when I get there, I feel like I have to buy something. What can I do? It’s for my friends.”

A full year consists of 31,536,000 seconds. Last year there were 24 million Tupperware Parties around the globe. That means a new Tupperware Party starts every 1.31 seconds. And each Tupperware Party generates an average of $10.63 of free cash flow.

North America and Europe (45% of sales) are mature markets and not going to grow much, but emerging markets (65% of sales) are growing fast, especially in Asia, the Tupperware region that already has the highest margins.

Risks would include anti-direct sales legislation/regulation, but I think Tupperware’s global breadth diversifies against this risk. It's impossible to think about his business without being reminded of the Herbalife (HLF) drama of the past couple years, but TUP says expressly in their 10-K’s that the “vast majority” of sales are by real consumers, and I actually believe them. They have one of the most transparent 10-K’s I've ever read.

Tupperware has little need for capex, so they throw of LOTs of free cash flow, which is in turn fueling LOTS of buybacks. Per the Annual Report:

"(a) Open market repurchases are being made under an authorization that runs until February 1, 2017 and allows up to $2 billion to be spent."

That’s a buyback authorization of $2B for a $3.2 billion company! That’s 63% of the current market cap. I have NEVER seen such an incredible buyback authorization. 

The CEO has been CEO for 17 very successful years, which is great to see.

I think that if you consider free cash flow growth, and buybacks, you can conservatively expect $9 in annual per-share FCF in the next 5-6 years. Assuming a 15x multiple on that free cash flow, and 10% growth rate for the dividends…you get a $150 total return in 5 years. That’s an 18.57% annualized rate of total return.

I’d value TUP around $85-90, and they’re selling around $64 today, so that’s a pretty big margin of safety.

TUP to outperform.

Regarding IBM

Selling divisions? Buybacks? Controversy?

Boy, oh boy, IBM is taking a beating.

Earnings misses, financial “engineering”, and of course PAYING someone to take a business off your hands...WOW. Talk about a train wreck. (No BNSF pun intended)

Those geezers Buffett AND Munger (see below) have clearly made a HUGE “unforced error” with IBM, one their largest equity investments of all time. 

"I was perfectly OK with it. It's a very Buffett-style play. It's simple. They announced what they were going to do and why they thought it was going to work. You could see how entrenched IBM was in many places, including the Burlington railroad. I think our business experience helps our investment judgment, and vice-versa. ... We've always said that what we like best was owning a wonderful business outright, and second best we like good ideas in securities. That has never changed." – Charlie Munger

http://www.fool.com/investing/general/2012/05/08/charlie-......

Buffett’s and Munger’s dementia is clearly starting to show. After all, they’re violating their own rule about not investing in tech companies.
I mean, come on, Buffett was recently spotted singing Frank Sinatra to 400 women.

https://www.youtube.com/watch?v=0l66YFP7UG0

Clearly, the man needs to retire, reinstate a proper dividend, and break Berkshire up into smaller parts to “unlock value”, right? 

OR wait…perhaps there’s another possibility?

Maybe, just maybe, the old man and his partner are going to go out with one last big victory for the shareholders.

Maybe, after 50 years of reading IBM annual reports, Buffett sees something that the masses have missed?

Maybe, Buffett happened to notice IBM taking a page from the book of Bill Anders, former General Dynamics CEO. GD sold off/exited unprofitable businesses, and bought back a ton of shares. Berkshire owned GD, and did quite well on that investment, if my memory serves.

General Dynamics was thought to be crazy, selling off this business, and that business. They were “manipulating” their earnings by buying back huge blocks of shares. Surely that can’t be considered “real” growth, can it?

http://www2.wiwi.huberlin.de/institute/hns/material/M_Dia......

Maybe, Buffett made a GOOD buy betting $10 billion on IBM at 15x earnings in 2011 @$175ish, and now you can make a FANTASTIC bet today buying IBM at 11.3x earnings in 2014 @ $169ish three years after Buffett, and make an absolute killing.

Maybe, the wisdom of the masses is wrong…again...and Buffett spent the day skipping around Kiewit Plaza happily buying MILLIONS of IBM shares. 

Maybe, just maybe, NOW is the time to be greedy when others are fearful?

Deere (DE) looks cheap today

Deere

DE has the 3 big things I like to see: 1) A consistent, multi-decade history of mouthwatering economics, 2) a dominant, wide-moat position in a critical industry that is unlikely to be disrupted (meaning those past mouthwatering economics are likely to continue into the future), and 3) an attractive price.

Take a look for yourself at DE over the past 20 years: High ROE, solid growth, decreasing share count, etc. Deere is an iconic brand, and the undisputed king of agricultural machinery. They also have decent, but not nearly as good, segments in construction, forestry, and home lawn care. The global need for those industries is not going away anytime soon.

Now, against my better judgment, I’m gonna nerd out on price…

As far as price, depending on the discount rate you use, DE is priced for basically ZERO growth. Specifically, at an 11% discount rate, assuming zero growth, DE would be worth about $82.63. DE is currently selling for $81.60. I don’t really use DCF’s to be an exact valuation, but more of a sanity check…that’s why Buffett says if you need to use a detailed DCF analysis, then the stock isn’t cheap enough.

I just played around with a reverse DCF (I like reverse DCF’s much more than normal DCF’s), inputting the current stock price, and fiddling with reasonable range of discount rates, a 0% perpetuity growth rate after year 10, looking to see what growth rate is currently “baked in” to Deere’s current price. The results were this: depending on a range of discount rates between 7% and 13%, DE is basically priced at an expected future EPS growth rate between -6.2% and 2.57% over the next 10 years, and assuming 0% growth after those 10 years.

Pardon, the silly finance math, the real point here is that anyone who knows DE knows that DE is going to grow EPS at more than 2.57% annualized over the next 10 years, and will probably keep growing well after that. I don’t know what rate DE will grow at…maybe 5%?, maybe 8%?, maybe more? But, I do believe that, in the long run, the probability is that it will be way more than 2.5%...therefore DE is underpriced. You don’t need super exact estimates when a DOMINANT business is this cheap…just like Buffett says…you just need to recognize a really WACKY low baked-into-the market-price growth assumption. 

Perhaps ironically, I actually expect DE’s EPS to drop over the next couple years since their margins and profitability are SO high right now…you can argue that DE’s ‘normalized earnings are closer to $7 per share (so we’re still talking a “normalized” PE under 12) but over the long run, say 10 years, I can’t see an annualized growth rate under 4%-5%. Otherwise stated, I can’t see DE having normalized EPS under $12 in 10 years…and I doubt that along that growth trajectory, DE won’t sell for 14x normalized earnings or more, at at least few points along that road. What THAT means, to me, is that it’s really hard to in vision a world where DE stock grows at LESS 7% annualized or more, at some point, over the next decade + you get your nearly 3% dividend as well. So maybe a total return around roughly 10% over the next decade…which is likely going to be much higher than the S&P 500.

Sorry for the long-winded pitch. At the end of the day, this seems to me to be another asymmetrical long-term bet, especially compared to the S&P 500. 

DE to outperform.

Winter is Coming...

Winter is coming…

…but I’m actually looking forward to it.

Pardon my Game of Thrones reference, but Mr. Market, like the weather, can fluctuate wildly day-to-day.

Also the market, like the weather, follows slightly more predictable patterns over longer periods of time.

I can’t predict what the temperature is going to be next week, but I know there’s a high probability that the weather will be warmer in July than it is in May.

The last few years in the stock market have been like a sweltering summer. Total returns over the past 5 years were 26.5%, 15.1%, 2.1%, 16.0%, and 32.4%.

But what are the next 5 years likely to bring?

Well, S&P 500 earnings are at all-time highs, and history shows that S&P 500 earnings declines occur fairly often.

Corporate profits margins are at all-time highs, and are likely to revert. (This time usually isn't different)

The market seems (to me) on the slightly expensive side at 18x earnings, but If we “normalize” those earnings to normal or closer-to-normal margins, then the market seems closer to 25x normalized earnings, which is VERY expensive.

I wouldn't be shocked to see the S&P 500 go basically nowhere for the next 5 years or so. 1880 on the S&P 500 in 2018 would not be surprising.

Again, I have no idea what the market is actually going to do between now and then, but it seems logical to me that the annualized return of the S&P 500 (not including dividends), between 5/21/14 and 2017-2019, will likely be less than 5% annualized.

So why am I excited for poor returns over the next few years?

Here’s why: as a rookie investor, at 25 years old, and have only been studying investing since about 2011, a raging bull market is really the ONLY market that I’ve ever experienced. (Lucky me)

Buffett said “It’s only when the tide goes out that you see who’s been swimming naked.”

Since I started investing 3 years ago the tide has only been coming in, coming in, and coming in.

The past 3 years have been a gravy train. The next 5 are almost certainly NOT going to be.

Inevitably, the tide will eventually have to go out, and when it does, I will see if I have been swimming naked or not. (It will also be fun to see who else gets caught with their pants down)

That is the EXCITING part. What I've learned over the past few years of this bull market will soon be put to the test.

Just as the tide must go out eventually, this “5 year summer” we've enjoyed in the stock market must eventually give way.

Winter is coming.

Thanks for reading,

-Philly Value Investor

And some fun links: 

http://www.multpl.com/s-p-500-earnings/

http://www.businessinsider.com/hussman-profit-margins-wil......

http://www.multpl.com/shiller-pe/

2014 ROE Champions List

It is time to unveil my 2nd annual Return on Equity Champions List.

 

The inspiration for this original screen list can be found in the 1987 Berkshire Hathaway Letter, see excerpt below:

 

"Here's a benchmark: In its 1988 Investor's Guide issue, Fortune reported that among the 500 largest industrial companies and 500 largest service companies, only six had averaged a return on equity of over 30% during the previous decade.  The best performer among the 1000 was Commerce Clearing House at 40.2%.

 

Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago.  That is no argument for managerial complacency.  Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized.  But a business that constantly encounters major change also encounters many chances for major error.  Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise.  Such a franchise is usually the key to sustained high returns.     

 

The Fortune study I mentioned earlier supports our view.  Only 25 of the 1,000 companies met two tests of economic excellence - an average return on equity of over 20% in the ten years, 1977 through 1986, and no year worse than 15%.  These business superstars were also stock market superstars: During the decade, 24 of the 25 outperformed the S&P 500.    The Fortune champs may surprise you in two respects.  First, most use very little leverage compared to their interest-paying capacity.  Really good businesses usually don't need to borrow.  Second, except for one company that is "high-tech" and several others that manufacture ethical drugs, the companies are in businesses that, on balance, seem rather mundane.  Most sell non- sexy products or services in much the same manner as they did ten years ago (though in larger quantities now, or at higher prices, or both).  The record of these 25 companies confirms that making the most of an already strong business franchise, or concentrating on a single winning business theme, is what usually produces exceptional economics." - (1987 Berkshire Hathaway Letter)

 

Inspired by that excerpt, every year, I conduct a modern day re-creation of that same study, by going page-by-page, through all the companies that Value Line covers. I screened by hand for companies with: 1) a 10 year average ROE over 20%, AND 2) Zero years in the past decade with a ROE below 15%.

 

Just 145 out of 1705 companies (or 8.5%) passed both of these two hurdles from 2004-2013.

 

Those 145 companies on this year’s list are:

 

***drumroll***

 

AAP, ACN, ADP, AMX, AMGN, APH, APOL, ATK, BAX, BCR, BDX, BF.B, BLL, BOH, BTI, CAT, CEB, CHRW, CI, CL, COH, COKE, COL, CPA, CPB, CPSI, CSCO, CTSH, DCI, DD, DE, DECK, DLTR, DRI, DST, DVA, EAT, EFX, EL, EMN, EMR, ENR, ESI, EV, FAST, FDO, FDS, FII, FMC, GGG, GILD, GIS, GPS, GRMN, GSK, HD, HIBB, HRB, HSY, IBM, IDXX, IFF, IGT, IMO, INFY, INTU, IT, JBHT, JCOM, JNJ, JOY, JWN, K, KMB, KMP, KO, KR, LDR, LH, LXK, LLTC, LLY, LMT, MA, MAT, MCD, MDT, MHFI, MIDD, MKC, MLHR, MMM, MMP, MNST, MRK, MSFT, MTD, NDSN, NKE, NSR, NUS, NVO, OMC, ORCL, PAYX, PBI, PEP, PETM, PETS, PII, POOL, PX, PZZA, ROK, ROL, ROST, SAP, SBUX, SCCO, SEIC, SHW, SLGN, STJ, STRA, SYK, SYY, TECH, TEN, THI, TJX, TROW, TSCO, TSM, TTC, TUP, UL, UPS, UTX, VAR, WAT, WDC, WMT, WEX, WU, YUM

 

92.8% of last year’s ROE Champions were Champions again this year. Here are the 7.2% that either failed to pass one of our two tests of economic strength, or were de-listed in 2013: ABT, AVP, AZN, FRX, JW.A, UNH, QSII all failed to pass at least one of our two tests of economic strength. CEC was acquired, and taken private.

 

Miscellaneous adjustment : McGraw Hill’s (old ticker MHP) successor company is now listed under the ticker MHFI after selling its education unit, and remains on the Champion list.

 

The only liberty I took with this was to make a handful of exceptions for wonderful business with negative ROE due to having negative equity. An example is WU, which has been insanely profitable, if you look at ROA and ROIC, but would be excluded due to having negative book value.

 

Lastly, just for fun – Here are the companies’ that will reach the 10th consecutive year of 15%+ ROE/10 yr AVG >20%, if they perform well in 2014, and would likely qualify for next year’s list:AAPL, NILE, BA, BKE, CE, CBRL, FTI, GWW, GES, HLF, HON, OI, RAI, TEF, TXN 

 

If you’ve made it this far, thanks for reading.

 

For those interested in my research, I have something new to add this year.

 

Though, I am not really a big fan of mechanical investing, I try to keep an open mind. I’ve always considered Greenblatt’s Magic Formula interesting, but somewhat inadequate. As a result, I have created my own experiment that follows a similar line of thinking, but is hopefully a slight improvement. There are two significant weaknesses in Greenblatt’s Formula, in my view. (The formula calls for a mechanical portfolio of businesses with high ROIC, and low EV/EBIT multiple.)

 

Weakness #1 is that only the most recent years ROIC is used. I truly believe that consistency of quality is key. By that I mean 40% ROTC last year is great, but if your 5 or 10 year average ROIC is below 10%, than I don’t want to invest there. My solution is to substitute Greenblatt’s trailing ROIC number with my ROE Champion list, which demands very consistent, high profitability, over the long-term.

 

Weakness #2 is that instead of a plain vanilla valuation multiple, which does not take future growth into account, I will I will replace Greenblatt’s EV/EBIT multiple with Value Line’s projected 3-5 yr total annualized return. Though this is certainly NOT a perfect metric, which I think is a better indicator of future returns than a blind PE or EV/EBIT multiple. For extra conservatism, I will rank stocks by the lower bound (for those familiar) of Value Line’s 3-5 total annualized return projection.

To test my hypothesis, I have created a brand new, Motley Fool CAPs tracking portfolio with the username MagicROEchamps. http://caps.fool.com/player/magicroechamps.aspx

 

This portfolio will consist of the top 20 stocks on my ROE Champion list, that have the highest lower-bound Value Line 3-5 year total annualized projection. (Again, for those not familiar with Value Line, this number can be thought of as Value Line’s minimum 3-5 year projected forward rate of total return.)

 

I will rebalance the portfolio on the first trading day of each month.

 

Should be a very interesting experiment! 

 

Thanks so much for reading, and please add some feedback to these ideas, as well as point out any errors or mistakes I made.

 

Happy Investing,

-John

Sit-On-Your-Ass Investing, and other concepts from Poor Charlie’s Almanack

Here's my review of the expanded 3rd addition of Poor Charlie’s Almanack.

The 532 page book is a bit pricey ($55 used, $150 new), but well worth it, in my humble opinion.

I hope you find this review both useful and enjoyable. Please forgive any grammatical errors, as I am sure you will find many.

 

My notes are organized by topic as follows:

1.       The Early Years

2.       A Multidisciplinary Approach to Business Analysis

3.       Keys to Investing Success

4.       Sit-On-Your-Ass Investing

5.       The Willingness to Change Your Own Mind

6.       On Life

7.       Miscellaneous

8.       Examples of Mental Models

9.       Charlie Munger’s suggested Reading List

 

Poor Charlie’s Almanack : The Wit and Wisdom of Charles T. Munger

 

“Success obtained via a combination of concentration, curiosity, perseverance, and self-criticism, applied through a prism of multidisciplinary mental models.”

 

“Acquire worldly wisdom and adjust your behavior accordingly. If your new behavior gives you a little temporary unpopularity with your peer group…then to hell with them.”

 

The Early Years:

As a boy, in Omaha, Charles Munger got his first job working at the Buffett & Son Grocery store, owned by Ernest Buffett, Warren’s grandfather. Charlie, like the other Buffett & Son employees, worked 12 hr shifts with no meals or breaks. Warren, six year younger than Charlie would later go to work at that same store, a few years after Charlie had moved on.

 

Young Charlie was very smart, but didn’t work very hard. He used a family connection to get into Harvard Law without a bachelors degree. He did very well at Harvard Law and got a decent job at a reputable firm. (keep in mind that lawyers today, make A LOT more money, relative to other career paths, than they did in the 1960s when Charlie started.)

 

Despite a good start, Charlie faced significant emotional challenges. By age 29 he had already married, divorced, and lost his young son to leukemia. During this time of his life, people recall often seeing Munger walking through the streets of Pasadena, CA, crying his eyes out, for hours at a time.

 

Munger eventually remarried and had A LOT of kids. (some acquired by marriage) Though a successful lawyer, Munger wanted much more money than a 1960s lawyer was bringing in. His quest for wealth was fueled, not by a desire for material possessions, but by a desire for independence. (Like his hero Ben Franklin) He turned to outside ventures and alternative ways to generate more income. In the mid-1950s and 60s, Munger started buying stocks, as well as equity in the private businesses of some of his clients. In 1961, he got into property development and developed condominiums and turned a large profit. From there, he took on other construction projects in the Pasadena area. He started his own law firm, Munger, Tolles & Hills. He then opened a small investment partnership soon thereafter. By 1964, Munger had acquired a nest egg of about 1.4 million.

 

While returning to Omaha, to visit family, Munger attended a dinner that included a fellow named Warren Buffett. Charlie, remembering the surname from his boyhood job at the Buffett & Son grocery store, hit it off with Warren right away. Warren tried to persuade Charlie to give up Law as soon as possible to focus on investing full time. He eventually did just that.

 

Over 14 years, the Munger Investment Partnership returned a compounded annual rate of return of 19.8% vs the Dow Jone’s return of just 5%. Though Munger and Buffett were partners in some investments, and traded ideas by phone almost daily, they both had separate partnerships. Eventually, their investments became so intertwined that it made more sense for them to more formally merge. Munger was chairman of Wesco. Buffett’s Berkshire bought 80% of Wesco, and Charlie became Vice-Chairman of Berkshire. The rest is history.

 

A Multidisciplinary Approach to Business Analysis:

According to Munger, many people suffer from “man with a hammer syndrome.” “To the man with only a hammer, every problem looks like a nail.” To avoid this common problem, Munger says we must develop a diverse mental “tool box”, by utilizing a multidisciplinary approach to investing (and life.)

 

“If you want to go through life like a one legged man in an ass-kicking contest, be my guest. But if you want to succeed like a strong man with two legs, you have to pick up these methods.”

 

“You must know the big ideas in the big disciplines and use them routinely – all of them, not just a few. Most people are trained in one model, economics, for example - and try to solve all problems in one way”. You know the old saying, “To the man with a hammer, the world looks like a nail.” This is a dumb was of handling problems.”

 

Munger incorporates history, psychology, mathematics, biology, and other academic disciplines into his mental toolbox for evaluating businesses. He refers this combined latticework of knowledge as “worldly wisdom.”

 

“Worldly wisdom is mostly very, very simple. And what I’m urging you to do is not that hard if you have the will to plow through and do it. And the rewards are awesome – absolutely awesome.” Munger says.

 

“I consistently see people rise in life who are not the smartest, and sometimes not even the most diligent. But they are learning machines. They go to bed at night a little wiser than they were that morning. And boy, does that habit help, particularly when you have a long run ahead of you.”

 

Keys to Investing Success:

“The number one idea”, Munger claims, “is to view a stock as an ownership of the business, and to judge the staying power of the business in terms of its durable competitive advantage. Look for more value in terms of discounted free cash flow than you are paying for. Move only when you have an advantage. It’s very basic. You have to understand the odds and have the discipline to bet only when the odds are in your favor. “

 

He also stresses the importance of staying within your “circle of competence.” [I assume you Fool blog readers understand that concept so I won’t repeat it here.]

 

When it comes to competitive advantage, Munger stresses that what matters is not how strong the advantage is today, but how strong it will be in 5, 10, even 20 or more year from now. Munger asserts that, “Anything less [than a long-term competitive advantage] is too risky.” Competitive destruction results in few businesses being able to survive over multiple generations. Munger cites a 1911 Buffalo Evening News clipping showing the 50 most important stocks on the NYSE. Of those 50, only GE survives to this day as a large independent business. He suggests that the best business to own would be “a simple, easy to understand, dominant business franchise, that can succeed in all types of economies.” He asserts that people overestimate the importance of quantitative methods of analysis and valuation, because they are easy to understand, and conversely, underestimates the importance of the durable competitive advantage and other qualitative aspects of a business, which are more difficult to understand.

 

Sit-On-Your-Ass Investing:

"If you buy a business just because it's undervalued, than you have to worry about selling it when it reaches its intrinsic value. That's hard. But if you can buy a few great companies, then you can sit on your ass. That's a good thing.”

 

“When Warren lectures at business schools, he says, “I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so you had twenty punches – representing all the investments that you get to make in a lifetime. And once you’ve punched through the card, you couldn’t make any more investments at all. Under those rules, you’d really think carefully about what you did, and you’d be forced to load up on what you’d really thought about. So you’d do much better.”

 

He advises, “You’re paying less to brokers, listening to less nonsense, and if it works, the tax system gives you an extra 1, 2 or 3 percentage points per annum.” In his view, a portfolio of three companies is plenty of diversification.

 

“The idea of excessive diversification is madness.” “Our experience tends to confirm a long held notion that being prepared, on a few occasions in a lifetime, [and] to act promptly in scale,…will often dramatically improve the financial results of that lifetime.”  “…All that is required is a willingness to bet heavily when the odds are extremely favorable, using resources available, as a result of prudence and patience in the past.”

 

“It takes character to sit there with cash and do nothing. I didn’t get where I am today, by going after mediocre opportunities. "If you say no to 90% of investing ideas, you're not missing much.

 

He then repeats the famous Buffett quote, “Few people ever get rich on their 7th best idea.”

 

The Willingness to Change Your Own Mind:

Charlie hates dogma. He bears not only a willingness, but an eagerness to find his own mistakes and learn from them.

 

“If Berkshire has made a modest progress, a good deal of it is because Warren and I are very good at destroying our own best-loved ideas. Any year that you don’t destroy one of your best-loved ideas is probably a wasted year.”

 

Keynes said “It’s not bringing in the new ideas that’d hard. It’s getting rid of the old ones.” And Einstein said it better, attributing his mental success to “curiosity, concentration, perseverance, and self-criticism.” By self- criticism he meant becoming good at destroying your own best loved and hardest-won ideas. If you can get really good at destroying your own wrong idea, that is a great gift.

 

Ask yourself, how am I fooling myself? Why is this company cheap? Is it for a good reason or for a superficial reason? Play devil’s advocate with yourself. Constant self-criticism is key to investment success.

 

“The best defense is that of the best physicists, who systematically criticize themselves to an extreme degree.” Munger says. Then he quotes Nobel laureate Richard Feynman, “The first principle is not to fool yourself, and you’re the easiest person to fool.”

 

On Life:

“Get out of debt, and have a want for very few material possessions. Also, be a very reliable person, learn from your experiences, don’t envy or resent others, and NEVER give up.”

 

“The way to win is to work, work, work, and hope to have a few insights.”

 

“The safest way to get what you want is to try and deserve what you want. It’s such a simple idea. It’s the golden rule. You want to deliver to the world what you would buy if you were at the other end.”

 

Miscellaneous:

“I should concede, at the outset, that I have never taken a single course in economics, nor tried to make a single dollar, ever, from foreseeing macroeconomic changes.” Be a business analyst, not a market analyst or macroeconomic analyst.

 

Munger believes that aggressive accounting is rampant in corporate America. "I think that, every time you see the word EBITDA, you should substitute the words, "bulls*** earnings."

 

“It's remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent."

 

Munger advocates create your own investing checklist and utilizing it every time you consider making an investment. "How can smart people so often be wrong? They don't do what I’m telling you to do: use a checklist to be sure you get all the main models and use them together in a multi-modular way." Guru investor Monish Pabrai, a Buffett/Munger fanboy in his own right, takes this advice literally.

 

Munger calls Value Line a wonderful tool. (Available for free in most libraries)

 

Examples of Mental Models Used in This Book:

Invert, always invert (Try to solve problems backwards)

Redundancy/backup system model (engineering)

Compound interest (math)

Combinations/permutations (math)

Fermat/Pascal systems

Decision Tree Theory

Accounting

Gaussian distribution

Break point/tipping point/autocatalysis models (physics/chemistry)

Darwin synthesis (biology) (Specifically how it relates to competitive destruction in capitalism)

Cognitive misjudgment (psychology)

Cost benefit analysis (economics)

Advantages of scale (economics) (Coca-Cola example)

Social Proof (psychology) (Coca-Cola example)

Pavlonian Association (biology) (Coca-Cola example)

Classical conditioning and Operant conditioning (more Pavlov)

Pari-mutuel betting (horse racing)

The power of incentives (psychology) (Example FedEx story)

Incentive-caused bias (Psychology)

Man w/ hammer tendency

Agency costs

Marginal utility

Consistency principle

***Munger claims that when multiple models combine in your favor, the “lollapalooza effect” kicks in, and the power of each individual model increases exponentially.***

 

Munger's Reading recommendations:

Munger quotes his famous partner, “In my whole life, I have known no wise people who didn’t read all the time – none, zero.” "I read everything. 10-K's and 10-Q's, biographies, histories, and 5 newspapers a day. Reading is key. Reading has made me rich over time." Then he adds an idea from Cicero’s that a man is never too old to learn something totally new. Munger cites Socrates learning to play the fiddle late in life as an example.

Here are Munger's reading recs:

Deep Simplicity: Bringing Order to Chaos and Complexity by John Gribbin

F.I.A.S.C.O.: The Inside Story of a Wall Street Trader by Frank Partnoy

Ice Age by John and Mary Gribbn How the Scots Invested the Modern World: The True Story of How Western Europe’s Poorest Nation Created Our World and Everything in It by Arthur Herman

Models of My Life by Herbert A. Simon

A Matter of Degrees: What Temperature Reveals About the Past and Future of Our Species, Planet, and Universe by Gino Segre

Andrew Carnegie by Joseph Frazier Wall

Guns, Germs, and Steel: The Fates of Human Societies by Jared M. Diamond

Influence: The Psychology of Persuasion by Robert B. Cialdini

Autobiography by Benjamin Franklin

Living Within Limits: Ecology, Economics, and Population Taboos by Garrett Hardin

The Selfish Gene by Richard Dawkins

Titan: The Life of John D. Rockefeller, Sr. by Ron Chernow

The Wealth and Poverty of Nations: Why Some Are So Rich and Some So Poor by David S. Landes

The Wealth of Nations by Adam Smith

The Warren Buffett Portfolio: Mastering the Power of the Focus Investment Strategy by Robert G. Hagstrom

Genome: The Autobiography of a Species in 23 Chapters by Matt Ridley

Getting to Yes: Negotiating Agreement Without Giving In by Roger Fisher, William Ury, and Bruce Patton

Three Scientists and Their Gods: Looking for Meaning in an Age of Information by Roger Wright

Only the Paranoid Survive by Andy Grove

Also Munger suggests your read: The Wall Street Journal, Forbes, Fortune, and Value Line.

 

The End.

If you've made it this far, thanks for reading this unusually long blog post. I hope you found it worthwhile.

 

Please leave some comments, questions, or general feedback.

 

Kind regards,

-Philly Value Investor