Charlie Munger: Full Transcript of Daily Journal Annual Meeting 2017

This week I had the great pleasure of hearing Charlie Munger speak at the Daily Journal Annual Meeting for the second time.  For two hours Charlie  captivated the audience with an abundance of whit, wisdom, and stamina.  It was a fantastic performance.  He truly is 93 years young.

I transcribed the full event from my audio recording which you may find below.  At each question throughout the transcript, I provided a clickable link to the precise spot where the question begins in an excellent video recording of the event posted on YouTube.  If you’d like an audio recording of the event I recommend my recording on SoundCloud.  Furthermore, Charlie provided a handout to the attendees.  I scanned them into a PDF document which you can access here.

I would like to thank Mr. Munger for energetically entertaining our questions and graciously sharing his wisdom, insights, and time with all of us.

I hope you all enjoy!

(Note: You will find that I frequently summarized the questions to Charlie, but as for Charlie’s and Gerry’s answers to the questions, I translated them verbatim and as accurately as possible.)

Charlie Discussing the Daily Journal Corporation:

Charlie: I usually talk a little bit before we take the questions.  And the essence of what’s going on here of course is that we have a corporation that was in a branch of the newspaper business.  And our branch of the newspaper business like most newspaper businesses has gone to hell compared to what it was in its peak years, and almost every other newspaper business is going to hell with no pardon, they’re just disappearing.  What we have is this computer software business where we’re serving the same customers to some extent except now they’re all over the country, even some of them outside the country, with this…we were selling software to all these courts and public agencies whereas before we were giving information to lawyers and other people, and publishing public notices and our software business is of a type where it’s a long tough slog.  But we’re slogging very well and we really love the people who are doing it for us, we’ve got a lot of wonderful people in our software business; the implementers, and the computer programmers, and people who deal with the public agencies, and the ethos of the place is very admirable.  Everybody is trying to get ahead here by doing the work right and serving the customers right, and having a lot of financial wherewithal where money is never a problem, and doing what we’re suppose to do.  It’s a pleasure to, people like Rick Guerin and myself, to watch all these young people doing this and of course we were very glad to be able to do it when we should be dead. (laughter)

A lot of you people came into this because Berkshire was successful and Guerin was successful and for various odd reasons of history, and most of you are accidentally in the software business, and I am too because Guerin did it when I wasn’t paying much attention.  I don’t do this kind of venture capital stuff.  And he doesn’t either, but he did it here.  So if there’s anything wrong with what happens in our software business, you’re looking at a man who caused it all over here. (laughter)  I’ll take credit for any successes.  But if there’s failure you’re looking at the man here who got us into this.

It is amazing to me, some of the things that are happening in our software business.  We just are getting a contract from South Australia.  Now if anybody told me when I was young, that the Daily Journal Company would be automating the courts of South Australia, I mean, I hardly know where it is.  Anyway, it’s amazing what’s happening and it’s a fair amount of fun to watch.  Probably because we’re doing more winning than losing.  I’ve never been able to enjoy losses the way some people do.  I would much rather win.  And I really like to work with good people instead of the opposite.  And we’ve got a lot of good employees in our software business.  We’ve got a bunch of implementer in Utah who are really good at it and we really trust.  And who our customers like, and we’ve got all these computer programmers and so forth around here, and a game of service like that when it’s complicated, what you have to do is minimize your glitches and (crawl out of them very rapidly in a way that your customers trust you.)  Our people were good at that and they get better and they’re trying to get ahead by being good at the service, not by hiring some politician as a consultant.  Some of our competitors do that kind of stuff.  But we’re trying to slog our way out by doing the work right.

When I was a lawyer, there was a saying that I’ve always used, “The best business-getter any lawyer ever has is the work that’s already on his desk.”  And that’s the basic ethos of our software business.  If we just keep doing it right, I don’t think we have to worry about the future.  Not that we won’t have down drafts and our failures, but we are actually grinding ahead slowly in that software business.  And it’s very interesting because Guerin and I know practically nothing about it.  And Gerry didn’t come up as a software engineer, so we’re basically doing something that’s quite difficult, we’re judging people because we don’t understand what the people do.  That’s what Andrew Carnegie did.  He didn’t know anything about making steel.  But he knew a lot about judging whether the people he was trusting were good at making steel.  And of course that’s what Berkshire’s done if you stop and think about it.  We have a lot of businesses at Berkshire that neither Warren our I could contribute much to, but we’ve been pretty good at judging which people are capable of running those businesses.

But this is pretty extreme here.  The little Daily Journal building going into the computer software business.  It’s a long slow kind of business.  RFPs.  The first time we contact a customer until we start making money may be 5 years.  So it’s like deciding to start prospecting for oil in Borneo or something.  And they just keep doing that over and over again, and the money goes out and the effort goes out, and it starts coming in five years from now.  I love that kind of stuff, not when I think we’re taking territory, it doesn’t look good when we write it off and we don’t report wonderful numbers or anything.  But if it makes sense in the long-term, we just don’t give a damn what it looks like over the short term.  And we know we’ve collected a bunch of shareholders that share our ideas.  After all we’re running a cult not a normal company.  And I think most of you feel that you’re willing to wait.

I lived all my life with people who were into deferred gratification.  In fact most of them will never have any fun.  They just defer gratification all the way to end, that’s what we do.  And it does cause you to get rich.  So we’re going to have a lot of rich dead people. (laughter)  We can excite a lot of envy.  A lot of you when the people walk by your grave and there will be this nice grave with this nice monument and they’ll say, “God what a great grave, I wish I were under.”  But at any rate, deferred gratification really does work if what you’re doing is growing a business that gets better and better and getting yourself so that your grave can look nice to outsiders.  Guerin and I have never taken any money out of this company in all these years.  We don’t take salaries, we don’t take directors fees.  We’re a peculiar example.  I wish our example spread more, because I think if you’re wealthy and own a big share of a company, and you get to decide what it does and whether it liquidates or whether it keeps going, that’s a nice position to be in, and maybe you shouldn’t try and grab all the money in addition.  That’s my theory of executive compensation.  And some of the old-fashioned guys like Carnegie never took any salary to speak of.  Cornelius Vanderbilt didn’t take any, of course he owned the whole place, practically, and he would have considered it beneath him, he lived on the dividends like the shareholders did.  So there’s a lot of that old fashioned ideas here in the Daily Journal Company.

Charlie Begins Q&A:

Charlie: I’ll first take a bunch of questions about the Daily Journal, and after that we’ll take question on anything you want to talk about.

Question 1: At last year’s meeting you talked about the milestone of getting the L.A. court system here at Journal Technologies and I was wondering, in the last year, as it has gone by, what good milestones have happened and what bad things have happened.

Charlie: Gerry you take that one.  I’ll answer it (shortly), it’s going fine.

Gerry: We have three case types for Los Angeles.  One case type went live last April, another case type will go live this coming July, and the third case type about 10 to 12 months later after that.  We have to work with the Los Angeles schedule, after all they have a lot of people to train.  And that becomes and very important factor.  Training is critical because if the end users aren’t trained properly, virtually everything falls apart.  And so that’s the schedule.  We discussed it this morning.  We meet with the court about 3 miles from here virtually every day.  We have a good team from the court and I think they’re very excited about what they’re doing, and that’s critical to us that the court feels good about the system.

Charlie: One good thing about what we’re doing is it’s slow and it’s agony in the delays between the first customer contact and finally getting into a decent revenue stream.  But once you succeed, it’s very sticky business.  Very sticky business.  And the fact that it’s difficult to do means it’s difficult for people to change much.  So if you go slog through all this tough territory where it’s (slogging through), there’s a reward out there somewhere, and we’re not in a small business.  It has way more potential than the original print business we had giving information about the (cases).  It’s a big market.  And the people have no option but to charge ahead.  These courts and district attorneys, public defenders, all these people were serving…they’re over-whelmed with options…better systems and more software.  So it’s a huge market.  And the fact that it’s so often to grind through.  It means that the people who want easy gratification don’t come in.  If it seems slow and painful to you, we kind of like it that way.

Questions 2: Your thoughts on Tyler Technologies.  How do you think your competitive position versus Tyler is doing.

Charlie: Well Tyler is an extremely aggressive company.  They were bigger faster and so on.  I like our ethos of operation better than I like theirs.  If I were buying software, I’d rather buy ours than theirs.  Our system is to keep fighting the game.  I wish all the customers I had in life were like Tyler.

Question 3: The rate of revenue growth is going down a little bit, while expenses are going up.  Any major milestones in the next 3 to 5 years that you think you’d like to get that you think would really help things along.

Charlie: I’ll take your first question.  It looks like we’re proceeding slowly, but we bought a bunch of contracts, in effect, for money, and we knew they were going to end, so we’re amortizing the cost of those contracts.  But really it was an anticipated decline that we got big revenues up front for taking.  So we’re getting ahead, there’s a little blip in the figures.

(Response to second question) Every contract that’s significant is a major jump.  The business is so big they’re whole states.  I mean this is a huge business and everybody is just scrambling at the first parts of something that’s going to grow bigger and bigger and last and last.  As long as we’re doing the work right, why it’s likely to work out right.

Question 4: Can you comment on Wells Fargo?

Charlie: Well of course Wells Fargo had a glitch.  The truth of the matter is that they made a business judgment that was wrong.  They got so caught up in cross-selling and so forth and having tough incentive systems that they got the incentive systems so aggressive that some people reacted badly and did things they shouldn’t.  And then they used some misjudgment in reacting to the trouble they got in.  I don’t think anything’s fundamentally wrong for the long-pull.  Wells Fargo, they made a mistake.  It was an easy mistake to make.

The smartest man I ever knew made a similar mistake.  Henry Singleton, who was the smartest single human being I knew in my whole life.  And Henry Singleton of Teledyne also had very aggressive incentive systems, like Wells Fargo.  And his customer in many of his subsidiaries was the government.  And of course it’s not that hard to cheat the government.  But his very aggressive incentive systems, 2 or 3 out of 20 subsidiaries cheated the government.  So all of a sudden he’s got three scandals at once.  It wasn’t that Henry was trying to cheat the government.  He just got a little aggressive in applying the incentives and he got blindsided.

That can happen to anybody.  I don’t regard getting the incentives a little aggressive at Wells Fargo as a mistake.  I think the mistake there was, when the bad news came, they didn’t recognize it rightly.  They made a mistake.  But what happens in a tough system like capital, you make a mistake like that and pretty soon you’re gone.

Question 5: For Gerry or Charlie.  Congratulations for inverting and not doing things wrong in regards to Daily Journal.  What’s your insight into the Alemeda court system and the problems that Tyler’s having over them.

Charlie: No, but I’m not dissatisfied with it.  I don’t think I want to criticize Tyler any more than I have.  One of our customers, you’ll be sad to know is having some problems with pleasing a customer…You can see the salt tears running down my cheeks. (laughter)

Question 6: Question on software fees in terms of your revenue lines.  What portion of that business is recurring?

Charlie: That is so complicated that I’m not even going to try to answer it.  I’m just going to answer it in substance.  There’s a lot that’s reoccurring if we stay in there.

You can’t look at our financial statements and make very good judgments about what’s going to happen.  It’s the nature of our game that’s confusing.  It confuses us a little bit.  So we’re not holding back on purpose, it’s a very complex, confusing, system.  You’ve got all these RFPs.  It’s very complicated.

Question 7: You purchased the building in Logan, which I believe is used exclusively in Journal Technologies, but in accounting, it’s under the traditional business, I’m wondering why?

Charlie: Gerry I give you that one.  He says, why is Logan, somehow in the traditional business?  It shouldn’t be.

Gerry: The Daily Journal purchased the building and they own the building.  And Journal Technologies pays rent to the parent company for that and the amount of rent is not, what we would consider, material from that perspective.  And because it’s owned by the Daily Journal that’s how we originally classify it.  No real significant reasons.  All the expenses on the Journal Technologies books.

Charlie: That’s some quirk of accounting.  It doesn’t really matter.

Question 8: Follow up on the question of incentives.  You were explaining at Wells Fargo you don’t have a problem with aggressive incentives.  Can you expand on that a little more?

Charlie: Well how do you know they’re aggressive until you try?  They didn’t react enough to the bad news fast enough.  And of course that a very dangerous thing to do.  I don’t think it impairs the future of Wells Fargo.  As a matter of fact, they’ll be better for it.  The one nice thing about doing something dumb is that you probably won’t do it again.

Question 9: Question in regards to someone early in their career trying to figure out which of several paths to pursue.  Two thoughts that seem helpful for this purpose are 1) figuring out which work you have the possibility to become the best at and 2) ascertaining which line of work would most help society.  Do you think these ideas are the right ones to focus on, and if so, how would you go about answering them.

Charlie: Well, in terms of picking what to do, I want to report to all of you, that in my whole life I’ve never succeeded much in something that I wasn’t interested in.  So I don’t think you’re going to succeed if what you’re doing all day doesn’t interest you.  You’ve got to find something you’re interested in because it’s just too much to expect of human nature that you’re going to be good at something that you really dislike doing.  And so that’s one big issue.  And of course you have to play in a game where you’ve got some unusual talents.  If you’re 5 foot 1, you don’t want to play basketball against some guy whose 8 feet 3.  It’s just too hard.  So you gotta’ figure out a game where you have an advantage and it has to be something that you’re deeply interested in.  Now you get into the ethical side of life, well of course you want to be ethical.  On the other hand, you can’t be just dreaming how you think the world should be run and that it’s too dirty for you to get near it.  You can get so consumed by some ideological notion particularly in a left-wing university.  It’s like you think you’re handling ethics and what you’re doing is not working.  And maybe smoking a little pot to boot.  This is not the Munger system.

My hero is Maimonides.  And all that philosophy and all that writing, he did after working 10 or 12 hours a day as a practicing physician all his life.  He believed in the engaged life.  And so I recommend the engaged life.  You spend all your life thinking about some politician who wants it this way or that way you’re sure you know what’s right, you’re on the wrong track.  You want to do something every day where you’re coping with the reality.  You want to be more like Maimonides and less like Bernie Sanders.

Question 10: Is American Express value proposition more in terms of payment or service and rewards?

Charlie: Well I’m going to give you an answer that will be very helpful to you because you’re somewhat confused about what the exact future of American Express will be…and I want to tell you, I’m confused too.  I think that if you understand exactly what’s going to happen to payment systems ten years out, you’re probably under some state of delusion, it’s very hard to know.  So if you’re confused, all I can say is “welcome to the club”.  They’re doing the best they can, they’ve got some huge advantages that they’re…it’s a reasonable bet.  But nobody knows.  I don’t know if IBM is going to sell that much of Watson.  I always say I’m agnostic on the subject.  You’re talking about payment system 10 years out, I’m agnostic on that too.  I think if you keep trying to do the right thing and you play the game hard, your chances are better.  But I don’t think those thing are knowable.  Think about how fast they changed.

Question 11: Do you think that domestic natural gas, exploration and production, is a good business despite the capital intensity?

Charlie: Well that’s a different subject, I have a different feeling about the energy business than practically anyone else in America.  I wish we weren’t producing all this naturally gas.  I would be delighted to have the condensate that’s coming out of our shale deposits just lie there untapped for decades in the future and pay a bunch of Arabs to use up their oil.  But nobody else in America seems to feel my way.  But I’m into deferred gratification.  Oil and gas is not going away and I think it’s just as important as the top soil in Iowa.  If any of you said, “oh goodie, I found a way to make money, we’ll ship all our top soil from Iowa to Greenland!”  I wouldn’t think that was a very good idea.  And so I don’t think that hastening to use up all of our oil and gas is a good idea.  But I’m practically the only one in the country that feels that way.  There’s not enough deferred gratification in it to please me.  But I don’t see any advantage…I regard our oil and gas reserves just as chemical feed stocks that are essential in civilization. (Leave aside) their energy content.  I’d be delighted to use them up more slowly.  By the way, I’m sure I’m right and the other 99% of the people are wrong.

But no, I don’t know…The oil and gas business is very peculiar.  The people who success in most other businesses are doing way more physical volume than they did in the past.  But a place like Exxon, the physical volume goes down by two thirds, it’s just that the price of oil goes up faster than the physical volume goes down.  That is a very peculiar way to make money.  And it may well continue, but it’s confusing, we’re not use to it.

Question 12: As an 18 year old interested in many disciplines, I was wondering how you can thrive as a polymath in a world that celebrates specialization.

Charlie: Well that’s a good question.  I don’t think operating over many disciplines as I do is a good idea for most people.  I think it’s fun, that’s why I’ve done it.  I’m better at it than most people would be.  And I don’t think I’m good at being the very best for handling differential equations.  So it’s in a wonderful path for me, but I think the correct path for everybody else is to specialize and get very good at something that society rewards and get very efficient at doing it.  But even if you do that, I think you should spend 10 or 20% of your time into trying to know all the big ideas in all the other disciplines.   Otherwise…I use the same phrase over and over again…otherwise you’re like a one legged man in an ass-kicking contest.  It’s just not going to work very well.  You have to know the big ideas in all the disciplines to be safe if you have a life lived outside a cave.

But no, I think you don’t want to neglect your business as a dentist to think great thoughts about Proust.

Question 13: Question about Lollapalooza effects.  What current event is causing you concern and how can you use that inter-disciplinary approach to spot them?

Charlie: Well, I coined that term the “Lollapalooza effect” because when I realized I didn’t know any psychology and that was a mistake on my part, I bought the three main text books for introductory psychology and I read through them.  And of course being Charlie Munger, I decided that the psychologists were doing it all wrong and I could do it better.  And one of the ideas that I came up with which wasn’t in any of the books was that the Lollapalooza effects came when 3 or 4 of the tendencies were operating at once in the same situation.  I could see that it wasn’t linear, you’ve got Lollapalooza effects.  But the psychology people couldn’t do experiments that were 4 or 5 things happening at once because it got too complicated for them and they couldn’t publish.  So they were ignoring the most important thing in their own profession.  And of course the other thing that was important was to synthesize psychology with all else.   And the trouble with the psychology profession is that they don’t know anything about ‘all else’.  And you can’t synthesize one thing you know with something you don’t if you don’t know the other thing.  So that’s why I came up with that Lollapalooza stuff.  And by the way, I’ve been lonely ever since. (laughter)  I’m not making any ground there.  And by the way, I’m totally right.

Question 14: My question relates to a comment you made some years ago about Warren Buffett.  I think you said that he has become a significantly better investor since he turned 65, which I found a remarkable comment.  I was wondering if you could share information about that, that maybe we haven’t heard before.  I know you’ve commented he’s a learning machine and we all know the aversion to retail that came out of the Diversified episode, and so on.  I’d just be interested if there’s something that’s changed about his risk assessment or his horizons or any color there would be fantastic to hear.  Thank you.

Charlie: Well, if you’re in a game and you’re passionate about learning more all the time and getting better and honing your own skills all the time, etc. etc.  Of course you do better over time.  And some people are better at that than others.  It’s amazing what Warren has done.  Berkshire would be a very modest company now if Warren never learned anything.  He never wouldn’t have never given anything back. I mean any territory he took he was going to hold it.  But what really happened was, we went out into the new fields of buying whole businesses and we bought into things like Iscar that Warren never would have bought when he was younger. Ben Graham would have never bought Iscar.  He paid 5 times book or something for Iscar.  It wasn’t in the Graham play.  And Warren who learned under Graham, just, he learned better over time.  And I’ve learned better.  The nice thing about the game we’re in, is that you can keep learning.  And we’re still doing it.  Imagine we’re in the press…for all of a sudden (buying) airline stocks?  What have we said about the airline business?  We thought it was a joke it was such a terrible business.  And now if you put all of those stocks together we own one minor airline.  We did the same thing in railroads, we said “railroads are no damn good, you know there’s too many of them, truck competition…”  And we were right it was a terrible business for about 80 years.  But finally they got down to four big railroads and it was a better business.  And something similar is happening in the airline business.

On the other hand, this very morning I sat down in my library with my daughter-in-law and she booked a round trip ticket to Europe including taxes, it was like 4 or 5 hundred dollars.  I was like, “we’re buying into the airline business?” (laughter)  It may work out to be a good idea for the same reason that our railroad business turned out to be a good idea, but there’s some chances it might not.  In the old days, I frequently talked to Warren about the old days, and for years and years and years, what we did was shoot fish in a barrel.  But it was so easy that we didn’t want to shoot at the fish while they were moving.  So we waited until they slowed down and then we shot at them with shotgun.  It was just that easy.  And it has gotten harder and harder and harder.  And now we get little edges…before, we had totally cinches.  It isn’t any less interesting.  We do not make the same returns we made when we could run around and pick this low hanging fruit off trees that offered a lot of it.

So now we go into things…We bought the Exxon position…You know why Warren bought Exxon?  As a cash substitute!  You would never have done that in the old days.  We had a lot of cash and we thought Exxon was better than cash over the short term.  That’s a different kind of thinking from the way Warren came up.  He’s changed.  And I think he’s changed when he buys airlines.  And he’s changed when he buys Apple.  Think of the hooting we’ve done over the years about high tech, ‘we just don’t understand it’, ‘it’s not in our central competency’, ‘the worst business in the world is airlines’.  And what do we appear in the press with?  Apple and a bunch of airlines.  I don’t think we’ve went crazy.  I think the answer is, we’re adapting reasonably to a business that’s gotten very much more difficult.  And I don’t think we have a cinch in either of those positions.  I think we have the odds a little bit in our favor.  And if that’s the best advantage we can get, we’ll just have to live on the advantage we can get.  I use to say you have marry the best person that will have you, and I’m afraid that’s a  rule of life.  You have to get by in life with the best advantage you can get.  And things have gotten so difficult in the investment world that we have to be satisfied with the type of advantage that we didn’t use to get.  On the other hand the thing that caused it to be so enormously difficult was when we got so enormously rich.  And that’s not a bad trade off.

Question 15: At last year’s meeting you said Donald Trump was not morally qualified to be President, and now that he is President, do you still agree with that, do you think he’s qualified in any capacity?

Charlie: Well I’ve gotten more mellow. (laughter)  I always try and think about the good as along with what’s not good.  And I think some of this stuff where they’re re-examining options about the whole tax system of the country, I think that’s a very constructive thing.  When Donald Trump says he wouldn’t touch Social Security when a lot of highfalutin Republicans have all kinds of schemes for (rising) Social Security, I’m with Donald Trump.  If I were running the world I would have his exact attitude about Social Security.  I wouldn’t touch it.  So he’s not wrong on everything and just because he isn’t like us…roll with it.  Accept a little danger.  What the hell, you’re not going to live forever at any how.

Question 16: What was the most meaningful thing you did with your life?

Charlie: Well, I think the family and children is the most meaningful thing most people do with their life.  And I’ve been reasonably fortunate…I don’t think I’ve been a perfect husband. I’m lucky to have had as much felicity as I got.  And I always needed a certain amount of toleration from the fair sex.  I started wrong and I never completely fixed myself.  I can tell this group…you come here as a cult to talk to a cult-leader?  I want to take you back in history, you’ll see what an inferior person you’re now trusting.

When I was a freshman in Omaha Central High, there was a friend of the family, a girl my age.  She had gone off to summer camp the year before and she met a blonde goddess.  A voluptuous 13 year old.  And I was a skinny under-developed whatever and so forth. ‘You gotta take my blonde goddess to this dance’.  And so I wanted to impress this ‘blonde goddess’ and so I pretended to smoke which I didn’t.  And she was wearing a net dress and I set her on fire!  (big laughter) But I was quick whittled and I through Coca-Cola all over her and in due time the fire was out.  And that’s the last I saw of the blonde goddess.

And then I said, ‘well I’ve gotta make more time with the girls’.  And I wanted to get a letter at Omaha Central High.  Of course I was no good at any sport.  So I went down to the rifle range and learned they gave letters in rifle shooting.  And I was so skinny that I could shoot a 100 in the sitting position by sitting cross-legged and putting one elbow on each foot.  Try it, you’ll break your neck.  But I could shoot a hundred every time.  So I was a good rifle shooter and they gave me a letter.  But I was so skinny and short and underdeveloped that it went from one arm pit to the other.  And I walked down the hallway trying to impress the girls and they wouldn’t turn their head.  What they said was, ‘how did a skinny little unattractive runt like that get a letter?’

And then I had another experience.  There was a girl I still remember, Zibby Bruington.  She was a senior and a very popular senior.  And I was a nerd sophomore.  And somehow she agreed with me to go to a party in one of the out-buildings at the Omaha Country Club.  Perhaps because she liked one of my friends who was a big strapping fellow.  So I took Zibby to this party in my 1934 Ford, and it sleeted and got rainy, and so forth.  And I managed to stick the Ford in the mud and I couldn’t get out of it.  And Zibby and I had to walk for several miles through sleet.  That was the last I ever saw of Zibby Bruington.  And then my car stayed in the mud and I neglected to put in anti-freeze and the temperature went way down suddenly and the block broke!  Because it was too expensive to fix.  I lost my car and my father wouldn’t by a new one because my father said, ‘why should I buy a new car for someone whose dumb enough not to put anti-freeze in it?’  This is the person you’re coming all this way to see!

My life is just one long litany of mistakes and failure.  And it went on and on and on.  And politics!  I ran to be the president of the DSIC in grade school, The Dundee School Improvement Association.  I had the most popular boy in school as my campaign manager.  I came in second by miles.  I was a total failure in politics.  There’s hardly anything I succeeded at.  Now, I tell you all this because I know a nerd when I see one.  And there are a lot of nerds here who can tell stories like mine. (big laughter)  And I want to feel it’s not hopeless.  Just keep trying.

Oh yeah, Guerin wants me to repeat the story of Max Plank.  According to the story, Max Plank when he won the Nobel Prize was invited to run around Germany giving lectures.  And a chauffeur drove him.  And after giving the lecture about 20 times, the chauffeur memorized it.  And he said, ‘you know Mr. Plank, it’s so boring, why don’t you sit in the audience and I the chauffeur will give your talk.’  And so the chauffeur got up and gave Max Plank’s talk on physics and some professor got up and asked some terrible question.  And the chauffeur said, ‘Well I’m surprised that in an advanced city like Munich, people are asking me elementary questions like that.  I’m going to ask my chauffeur to answer that!’ (laughter)

While I’m telling jokes I might tell one of my favorite stories about the plane that’s flying over the Mediterranean.  The pilots voice comes on and says, ‘A terrible thing just happened.  We’re losing both engines, we’re going to have to land in the Mediterranean.’  And he says, ‘The plane with stay afloat for a very short time, and we’ll be able to open the door just long enough so that everybody can get out.  We have to do this in an orderly fashion.  Everybody who can swim go to the right wing and stand there.  And everybody who can’t swim go to the left wing and just stand there.  Those of you on the right wing, you’ll find a little island in the direction of the sun.  It’s two miles off.  And as the plane goes under, just swim over to the island, you’ll be fine.  For those of you on the left wing, thank you for flying Air Italia.” (big laughter)

Question 17: With regard to the proliferation of index funds, do you think there will be an issue with liquidity any time we go through another large crisis?  Do you think that will create large discrepancies between the price of the index fund and the value of the securities underneath?

Charlie: Well, the index funds of the S&P is like 75% of the market.  So I don’t think the exact problem you’re talking about is going to be a big problem because you’re talking about the S&P index.  But.  Is there a point where index funds theoretically can’t work a course?  If everybody bought nothing but index funds, the whole world wouldn’t work as people expect.  There’s also the problem…one of the reasons you buy a big index like the S&P.  Is because if you buy a small index, and it gets popular, you have a self-defeating situation.  When the nifty-fifty were the rage, JP Morgan talked everybody into buying just 50 stocks.  And they didn’t care what the price was, they just bought those 50 stocks.  Of course in due time, their own buying forced those 50 stocks up to 60 times earnings.  Where upon it broke and everything went down by about two-thirds quite fast.  In other words, if you get too much faddishness in one sector or one narrow index, of course you can get catastrophic changes like they had with the nifty-fifty in that former era.  I don’t see that happening when the index is three-quarters of the whole market.

The problem is that the whole thing can’t work perfectly forever.  But it will work for a long time.  The indexes have caused just absolute agony among the intelligent investment professionals.  Because basically 95% of the people have almost no chance of beating it over time.  And yet all the people expect if they have some money, they can hire somebody who will let them beat the indexes.  And of course the honest sensible people know they’re selling something they can’t quite deliver.  And that has to be agony.  Most people handle that with denial.  They think if we’re better next year…they just don’t want to think about that.  I understand that, I mean I don’t want to think of my own death either.  But it’s a terrible problem beating those indexes.  And it’s a problem that investment professional get didn’t have in the past.  What’s happening of course is the prices for managing really big sums of money are going down, down, down, 20 basis points and so on.  The people who rose in investment management didn’t do it by getting paid 20 basis points.  But that’s where we’re going I think in terms of people who manage big portfolios of the American Equities in the equivalent of the S&P.  It’s a huge, huge, problem.  It makes your generation of money managers to have way more difficulties and causes a lot of worry and fretfulness.  And I think the people who are worried and fretful are absolutely right.

I would hate to manage a trillion dollars in the big stocks and try and beat the indexes.  I don’t think I could do it.  In fact if you look at Berkshire, take out a hundred decisions, which is like two a year.  The success of Berkshire came from two decisions a year over 50 years.  We may have beaten the indexes, but we didn’t do it by having big portfolios of securities and having subdivisions managing the drugs, and subdivisions…and so, the indexes are a hell of a problem for you people.  But you know, why shouldn’t life be hard?  It’s what had to happen, what’s happened now.  If you take these people doing some of those early trading by computer algorithms that worked.  Then somebody else would come in and do the same thing with the same algorithm and play the same game.  And of course the returns went down.  Well that’s what’s happening in the whole field.  The returns you’re going to get are being pushed down by the progress of the sons.

Question 18: First question: What books or experiences were most formative to you in your early career? Second question: Where and how do you tell your most ambitious grandchildren to look for business opportunities.

Charlie: Well I don’t spend any time telling my grandchildren what business opportunities to look for.  I don’t have that much hope. (laughter)  I’m going to have trouble getting my grandchildren to work at all!  Anyway, I don’t think there’s an easy way to handle a problem of doing better and better with finances.  Obviously if you’re glued together and honorable and get up every morning and keep learning every day and you’re willing to go in for a lot of deferred gratification all your life, you’re going to succeed.  It may not be as much as you want.  But you’re going to success.  And so the main thing is to just keep in there, and be glued together, and get rid of your stupidities as fast as you can.  And avoid the bad people as much as you can.  And you’ll do reasonably well.  But try teaching that to your grandchildren.  I think the only way you’ve got a chance is sort of by example.  If you want to improve your grandchildren the best way is to fix yourself.

Oh books.  You cultist send me so many books that I can scarcely walk into my own library.  So I’m reading so many now because I never throw one away, I at least scan it.

I’ve just read this new book by Thorp, the guy who beat the dealer in Las Vegas.  And then he did computer algorithm trading.  And I really liked the book.    For one thing, the guy had a really good marriage and he seemed grateful for it.  And it was touching.  For another he was a very smart man.  He was a mathematician using a high IQ, to A) beat the dealer in Las Vegas and so forth and the B) use these computer algorithms to do this massive trading.  I found it very interest and since some of you people are nerds, and maybe you might like a love story.  I recommend Thorp’s new book.

It’s an interesting thing to do to beat the dealer in Las Vegas…wearing disguises and so on.  And Peter Kaufman told me a story about somebody he knows that did the same thing as Thorp did, but he did it more extreme.  He wore disguises and so forth.  He won four million dollars I think, in the casinos.  And that was hard to do because casinos don’t like playing against people who might win.  And then he went into the stock market where he made four billion dollars!  Again, clever algorithms.  You know, these people are mathematically gifted.  It’s still going on.  And I don’t think many of you are going to do it.  There can’t be many people who are mathematically gifted enough, manipulate statistics and everything else so well that they find little algorithms that will make them four billion dollars.

But there are a few.  And so some of them started just like Thorp.  And so Thorp’s book is interesting.  So I recommend it for you.

Question 19: Question on Filial piety.  In this generation, how can we fulfill our filial duties?

Charlie: I like filial piety.  They worship old men.  Rich old men.  That is my kind of a system. (laughter) But I think the idea of caring about your ancestors and caring about your traditions, I think all that stuff is a big part of what’s desirable.  I really admire the Confucians for that notion that it’s not a game that’s played just in one life.  It’s a game where you’re handing the baton off and you’re accepting the baton from your predecessor.   So if filial piety is your game, why I think it’s a very good thing.  Think about how rootless we’d be if we had no families at all, no predecessors, no decedents, it would be a very different life.  Think what we owe to people who figure out things in the past that make our civilization work.  So I’m all for filial piety and its close cousins.

Question 20: You’ve said, “any year in which you don’t destroy one of your best loved ideas is a wasted year.” It’s well known that you helped coached Warren towards quality which was a difficult transition for him.  I was wondering if you could speak to the hardest idea that you’ve ever destroyed.

Charlie: Well I’ve done so many dumb things.  That I’m very busy destroying bad ideas because I keep having them.  So it’s hard for me to just single out from such a multitude.  But I actually like it when I destroy a bad idea because I think I’m on the…I think it’s my duty to destroy old ideas.  I know so many people whose main problem of life, is that the old ideas displace the entry of new ideas that are better.  That is the absolute standard outcome in life.  There’s an old German folk saying, “We’re too soon old and too late smart.”  That’s everybody’s problem.  And the reason we’re too late smart is that the stupid ideas we already have, we can’t get rid of!  Now it’s a good thing that we have that problem, in marriage that may be good for the stability of marriage that we stick with our old ideas.  But in most fields you want to get rid of your old ideas.  It’s a good habit and it gives you a big advantage in the competitive game of life…other people are so very bad at it.  What happens is, as you spout ideas out, what you’re doing is you’re pounding them in.  So you get these ideas and then you start agitating them and saying them and so forth.  And of course, the person you’re really convincing is you who already had the ideas.  You’re just pounding them in harder and harder.  One of the reasons I don’t spend much time telling the world what I think about how the federal reserve system should behave and so forth.  Because I know that I’m just pounding the ideas into my own head when I think I’m telling the other people how to run things.  So I think you have to have mental habits…I don’t like it when young people get violently convinced on every damn cause or something.  They think they know everything.  Some 17 year old who wants to tell the whole world what ought to be done about abortion or foreign policy in the middle east or something.  All he’s doing when he or she spouts about what he deeply believes is pounding the ideas he already has in, which is a very dumb idea when you’re just starting and have a lot to learn.

So it’s very important that habit of getting rid of the dumb ideas.  One of things I do is pat myself on the back every time I get rid of the dumb idea.  You could say, ‘could you really reinforce your own good behavior?’  Yeah, you can.  When other people won’t praise you, you can praise yourself.  I have a big system of patting myself on the back.  Every time I get rid of a much beloved idea I pat myself on the back.  Sometime several times.  And I recommend the same mental habit to all of you.  The price we pay for being able to accept a new idea is just awesomely large.  Indeed a lot of people die because they can’t get new ideas through their head.

Question 21A: My perception is that the (oil and gas) industry itself has continuously gotten more complex and technical, and as the economy expands and you have more division of labor and specialization, it seems to me that it can be very hard for investors unless there’s more specialization.  (Charlie interjects)

Charlie: Of course.

Question 21B: Do you think that capital allocators are going to need to become more specialized going forward?

Charlie: Well you petroleum people of course have to get more specialized because the oil is harder to get and you have to learn new tricks to get it.  And so you’re totally right.  Generally, specialization is just the way to go for those people.  It’s just I have an example of something different.  It’s awkward for me because…but I don’t want to encourage people to do it the way I did because I don’t think it will work for most people.  I think the basic ideas of being rational and disciplined and deferring gratification, those will work.  But if you want to get rich the way I did, by learning a little bit about a hell of a lot, I don’t recommend it to others.

Now I’ve get a story there that I tell.  A young man comes to see Mozart, and says, “I want to compose symphonies.”  And Mozart says, “You’re too young to compose symphonies.”  He’s 20 years old and the man says, “But you were composing symphonies when you were 10 years old.”  And Mozart says, “Yeah but I wasn’t running around asking other people how to do it.”

I don’t think I’m a good example to the young.  I don’t want to encourage people to follow my particular path. I like all the general precepts, but I would not…if you’re a proctologist, I do not want a proctologist who knows Schopenhauer, or astrophysics.  I want a man whose specialized.  That’s the way the market is.  And you should never forget that.  On the other hand, I don’t think you’d have much of a life if all you did was proctology. (laughter)

Question 22: Warren and you are known for saying that if you worked with a small sum of capital, $10 million, Warren publicly said that he could guarantee that he could compound that at 50%  a year.  So my question is, can you provide some examples?  And I would kindly ask that you provide as many examples as possible, and be specific as possible.

Charlie: Well, the minute I hear somebody that really wants to get rich, at a rapid rate, with specifics.  That is not what we try and do here.  We want to leave some mystery so that you yourself can amuse yourself finding your own way.  You know the good ideas that I’ve had in my life are quite few.  But the lesson I can give you is a few is all you need and don’t be disappointed.  When you find the few of course, you’ve got to act aggressively.  That’s the Munger system.  And I learned that indirectly from a man I never met.  Which was my Mother’s maternal grandfather.  He was a pioneer when he came out to Iowa and fought in the Blackhawk Wars and so on.  And eventually after enormous hardship, well he was the richest man in town and he owned the bank and so on.  As he sat there in his old age, my mother knew him because she’d go to Algona, Iowa where he lived and had the big house in the middle of town.  Iron fence, capacious lawns, big barns.  What Grandpa Ingham use to tell her is, ‘there’s just a few opportunities you get in a whole life’.  This guy took over Iowa when the black topsoil in Iowa was cheap.  But he didn’t get that many opportunities.  It was just a few that enabled him to become prosperous.  He bought a few farms every time there was a panic you know.  And leased them to thrifty Germans, you couldn’t lose money with leasing a farm to a German in Iowa.  But he only did a few things.  And I’m afraid that’s the case…you’re not going to find a million wonderful ideas.  These people with the computer algorithms do it, but they have a computer sifting the who world.  It’s like placer mining.  And of course every niche they’re in, if somebody else comes in, the niche starts leaching away.  And I don’t think it’s that honorable to make a living that way.  I’d rather make my money in some other way than outsmarting the trading system so I have a little computer algorithm that just leaches a little out of everybody’s trade.  I always say that those people have all the social utility of a bunch of rats in a granary.  It’s not that great a way to make money.  I would say if you make your money that way that you should be very charitable with it because you’ve got a lot to atone for. (laughter) I don’t think it’s an ambition we should encourage.

The rest of us who aren’t just leaching a little off the top because we’re great at computer science, and that’s what this room is full of.  And if you’re not finding it harder now, you don’t understand it.  That’s my lesson.

Question 23: What’s your favorite industry and why is it your favorite?

Charlie: Well, my favorite industry is taking care of my own affairs. (laughter) And it’s fun it’s creative, it’s the job that life has given me, and I think that you should do the job well that life gives you.  A lot of the places where the industries are doing a great job for the world, it’s very hard to make money out of it.  Because these wild enthusiasms come into it.  I don’t have a favorite industry.

Question 24: Is there any current monkey-business in corporate America that worries you?

Charlie: Well the answer is yes, but not as extreme as Valeant.  That was really something.  That was really something.  I probably should have done that. (laughter)  But you people come so far, and since you’re cult members you like being here.  And I feel an obligation to tell you something sort of interesting and I just went straight into Valeant that year.  It was really pretty disgusting.  What’s interesting is how many high-grade people that took in.  It was too good to be true.  There was a lot wrong with Valeant.  It was so aggressive.  It was drugs people needed.  It was just…take the difference between Valeant and the Daily Journal Company.  When the foreclosure boom came, we had 80% of the foreclosure business in our area.  It’s a big area, Southern California and Northern California too.  It would have been very easy for us to raise the prices and make, I don’t know, $50 million more or something like that, when all these people are losing their houses.  A lot of them are very decent people.  It didn’t ever…the idea that just right in the middle of that we’d make all the money we could?  Which some of our competitors did by the way.  We just didn’t do it.  I don’t think capitalism requires that you make all the money that you can.  I think there are times when you should be satisfied based on...just ideas of decency And at Valeant they just look at it like a game like chess.  They didn’t think about any human consequences, they didn’t think about anything but getting what they wanted which was money and glory.  And they just stepped way over the line.  And of course in the end they were cheating.

But I don’t have a new one.  I got a lot of publicity over that Valeant thing.  I’m not looking for…I don’t want this room to have twice as many people next year.  And I don’t want me not to be here either. (laughter)

Question 25: My question relates to a talk you gave to the foundation of financial officers in 1998 here in California.  And in that talk, you were critical of the complexity and the expense of many foundation portfolios and you said specifically, “An institution with almost all wealth invested long-term in just three fine domestic corporations, is securely rich.”  And you gave as your example the Wicker Foundation and Coca-Cola.  So if you had a foundation today with let’s say a billion dollars, would you be comfortable with it being invested in just three stocks?

Charlie: Well, let’s take the foundation…I’ll change your question around (in the way that I want to answer it). (laughter)  Am I comfortable with a non-diversified portfolio?  Of course…if you take the Munger’s, I care about the Munger’s.  The Munger’s have three stocks.  We have a block of Berkshire, we have a block of Costco, we have a block of Li Lu’s fund, and the rest is dribs and drabs.  So am I comfortable?  Am I securely rich?  You’re damn right I am.  Could other people be just as comfortable as I who didn’t have a vast portfolio with a lot of names in it?  Many of whom neither they or their advisors understand? Of course they’d be better off if they did what I did.  And is three stocks enough?  What are the chances that Costco’s going to fail?  What are the chances that Berkshire Hathaway’s going to fail?  What are the chances that Li Lu’s portfolio in China’s going to fail?  The chances that any one of those things happening is almost zero.  And the chances that all three of them are going to fail?

That’s one of the good ideas I had when I was young.  When I started investing my little piddly savings as a lawyer,  I tried to figure out how much diversification I would need if I had a 10% advantage every year over stocks generally.  I just worked it out.  I didn’t have any formula, I just worked it out with my high school algebra.  And I realized that if I was going to be there for thirty or forty years, I’d be about 99% sure to do just fine if I never owned more than three stocks and my average holding period is 3 or 4 years.  Once I’d done that with my little pencil, I just…I never for a moment believed this balderdash they keep…why diversification…diversification is a rule for those who don’t know anything.  Warren calls them ‘know-nothing investors’.  If you’re a ‘know-nothing investor’ of course you’re going to own the average.  But if you’re not a know-nothing investor, if you’re actually capable of figuring out something that will work better, you’re just hurting yourselves looking for fifty when three will suffice.  Hell one will suffice if you do it right.  One.  If you have one cinch, what else do you need in life.

And so the whole idea that the ‘know-something’ investor needs a lot of diversification.  To think that we’re paying these investors to teach this crap to our young.  And people think they should be paid for telling us to diversify.  Where it’s right, it’s an idiot decision.  And where it’s wrong, you shouldn’t be teaching what’s wrong.  What’s gone on in corporate finance teaching is that people are getting paid for dispensing balderdash.  And since I never believed that it was a great help to me, it helps if you’re out in the market and the other people are believing balderdash and you know what the hell’s going on.  It’s a big help.  So of course you don’t want a lot…if you’re Uncle Horace who has no children has an immense business which is immensely secured and powerful.  And he’s going to leave it all to you if you come to work in the business.  You don’t need any diversification.  You don’t need any corporate finance professors, you should go to work for Uncle Horace.  It’s a cinch.  You only need one cinch!  And sometimes the market gives you the equivalent of an Uncle Horace.  And when it does, step up to the pie-cart with a big pan.  Pie carts like that don’t come very often.  When they do you have to have the gumption and the determination to seize the opportunity shrewdly.  I was lucky.  Imagine learning that from your dead great-grandfather, at a very young age.  But you know I spent my whole life with dead people.  They’re so much better than many of the people I’m with here on earth.  All the dead people in the world, you can learn a lot from them.  And they’re very convenient to reach.  You reach out and grab a book.  None of those problems with transportation. So I really recommend making friends among the immanent dead.  Which of course I did very early.  And it’s been enormously helpful.  Some of you wouldn’t have helped me.  But Adam Smith really did.

Question 26: Question on Irish economy and Irish banking.  Berkshire Hathaway was a shareholder in Irish banks pre-2008.  Could you comment on how the Irish economy and Irish banking system proceeds with the U.K. not being part of the European Union going forward.

Charlie: Well, that of course was a mistake, and it was a mistake we shouldn’t have made because both Warren and I know that you can’t really trust the figures put out by the banking industry.  And the people who run banks are subject to enormous temptations that lead them astray because it’s easy to make a bank report more earnings.  By a thing that any idiot could do which is make it a little more gamey.  And of course that’s dangerous.  And the temptation are very great.  So we shouldn’t have made that mistake, but we did.  And that’s a good lesson too, that even if you’re really good at something you will occasionally drift into a dumb mistake.  And now that’s the question about the bank.  They went crazy in Ireland…the bankers.  And we went crazy when we trusted the damn statements.  And it was a mistake.

Now what Ireland has done was very smart…in reducing all of these taxes.  Now they have English speaking people with practically no taxes.  And there’s a fair amount of charm and so forth in Ireland.  It’s not like it’s a terrible place to be.  They just sucked in half the world into Ireland where they got these…Gates went there very early with Microsoft, and so on.  And they took a place that was really a backward place that had a sort of internal civil war for 60 or 70 years, and bad opportunities, and they really brought in a lot of prosperity.  And they did that by this competitive lowering of taxes and so on.  So it worked for Ireland.  I think Ireland deserves a lot of credit for the way they advanced their country.  And of course they were going to have a thing where all the countries keep trying to reduce their taxes to suck in the foreign…but it won’t work for everybody.  But it did work for Ireland.  I think Ireland deserves a lot of credit, and of course they recovered very well from a very major collapse.  Irish are like the Scottish.   I always think that those Gallic’s are pretty unusual people.  And I’m very glad that I had a Scottish-Irish great-grandmother.

Question 27: My question is in regards to Lee Kuan Yew.  You’ve on several occasions spoken about the economic miracle that is Singapore and how it’s been transferred on by Deng Xiaoping to China.  What are your thoughts about India that’s going through a similar change with the prime minister who also idolizes his people and wants to create a similar sort of situation.  I’d like you’re thoughts on that.  Thank you.

Charlie: Well that’s a very intelligent question, and I’m not saying all the other questions weren’t. (laughter)  I regard Lee Kuan Yew…may have been the best nation builder that ever lived.  He took over a malarial swamp with no assets.  No natural resources.  Surrounded by a bunch of Muslims who hated him.  In fact he was spat out by a Muslims country.  They didn’t want a bunch of damn Chinese in their country.  That’s how Singapore was formed as a country, the Muslims spat it out.  And so hay, here he is, no assets, no money, no nothing.  People were dying of malaria.  Lots of corruption.  And he creates in a very short time, by historical standards, modern Singapore.  It was a huge, huge, huge success.  It’s such a success that there’s no other precedent in the history of the world that is any stronger.  Now China’s more important because there are more Chinese, but you can give Lee Kuan Yew a lot of the credit for creating modern China.  Because a lot of those pragmatic communist leaders, they saw a bunch of Chinese that were rich when they were poor, and they said, ‘to hell with this!’  Remember the old communist said, ‘I don’t care whether the cat is black or white, I care whether he catches mice.’  And he wanted some of the success that Singapore got and he copied the playbook.  So I think the communist leadership that copied Lee Kuan Yew was right, I think Lee Kuan Yew was right.  And of course I have two busts of somebody else in my house.  One is Benjamin Franklin, and the other is Lee Kuan Yew.  So, that’s what I think of him.

Now you turn to India.  And I would say, I’d rather work with a bunch of Chinese than I would the Indian civilization mired down, case system, over-population, assimilated the worst stupidities of the democratic system, which by the way Lee Kuan Yew avoided, it’s hard to get anything done in India.  And the bribes are just awful.  So all I can say is, it’s not going to be easy for India to follow the example of Lee Kuan Yew.  I think that India will move ahead.  But it is so defective as a get-ahead…the Indians I know are fabulous people.  They’re just as talented as the Chinese, I’m speaking about the Indian populace.  But the system and the poverty and the corruption and the crazy democratic thing where you let anybody who screams stop all progress?  It mires India with problems that Lee Kuan Yew didn’t have.  And I don’t think those Indian problems are always easy to fix. Let me give you an example. The Korean steel company, POSCO, invented a new way of creating steel out of lousy iron ore and lousy coal.  And there’s some province in India that has lots of lousy iron ore and lot of lousy coal.  Which is there’s not much use for.  And this one process would take their lousy iron ore and the coal and make a lot of steel.  And they got a lot of cheap labor.  So POSCO and India were made for each other.  And they made a deal with the province to get together and use the POSCO know how and the India lousy iron ore and lousy coal.  And 8 or 9 or 10 years later with everybody screaming and objecting and farmers lying down in the road, or whatever’s going on, they canceled the whole thing.  In China they would have just done it.  Lee Kuan Yew would have done it in (Singapore).  India is grossly defective because they’ve taken the worst aspects of our culture, allowing a whole bunch of idiots to scream and stop everything. And they copied it!  And so they have taken the worst aspects of democracy and they forged their own chains and put them on themselves.  And so no I do not like the prospects of India compared to the prospects of…and I don’t think India’s going to do as well as Lee Kuan Yew.

Question 28: What happened 1973 and 1974 when your investment firm lost over half?

Charlie: Oh, that’s very simple.  That’s very easy.  That’s a good lesson.  That’s a good question.  What happened is the value of my partnership where I was running, went down by 50% in one year.  Now the market went down by 40% or something.  It was a once in 30 year recession.  I mean monopoly newspapers are selling at 3 or 4 times earnings.  At the bottom tick, I was down from the peak, 50%.  You’re right about that.  That has happened to me 3 times in my Berkshire stock.  so I regard it as part of manhood.  If you’re going to be in this game for the long pull, which is the way to do it, you better be able to handle a 50% decline without fussing too much about it.  And so my lesson to all of you is conduct your life so that you can handle the 50% decline with aplomb and grace.  Don’t try to avoid it. (applause)  It will come.  In fact I would say if it doesn’t come, you’re not being aggressive enough.

Question 29: Regarding biases of human misjudgment.  How do you evaluate, handle, and manage people, knowing they might exhibit and suffer from biases that you are not?  And how have you and Mr. Buffett become such good judges of character and not just skills and abilities?

Charlie: Well I think partly we look smart because we pick such wonderful people to be our partners and our associates, even our employees.  And that’s going on right here.  Gerry Salzman is not normal.  He looks normal, but he’s a damn freak.  Gerry does things across 2 or 3 disciplines that are almost beyond human.  And he’s always been that way.  By the way he’s just another mid-westerner.  He’s come out of the soil back there.  So we’ve been very lucky to have his wonderful people.  I wish…I’m not quite sure…I think one thing we’ve done that’s helped us to get wonderful people, I always say the best way to get a good spouse is to deserve one.  And the best way to get a good partner is to be a good partner yourself.  And I think Warren and I have both done good with that.  But whatever the reason we’ve had these marvelous partners, and they make us look a lot better than we are.  You wouldn’t even be here if Gerry Salzman weren’t here.  We did not have a number two choice to run the Daily Journal.  And by the way that happens to me all the time.  We have an executive search or something.  The difference between the number one and number two is like going off a cliff.   And we really…we need one, but there aren’t three good ones to pick, where they’re all good and one’s a little better.  Every executive search I’ve have, it seems there’s one guy whose fine and everybody else is a pigmy.  I think good people are hard to find.  And people like Warren and I have had wonderful people who we’ve worked with all our lives time after time.  That’s one of the reasons Warren says he tap dances to work…you’d tap-dance too if you interfaced with people Warren interfaced with all day.  They’re wonderful people and they win all the time instead of losing.  Who doesn’t like winning in good company?  If you can duplicate that, why you’ve got a great future.  I think we were a little lucky.  And I can’t give you any luck.

Question 30: We have a Chinese platform that focuses content on people trying to invest capital outside of China.  They haven’t been able to invest (outside China) because of capital controls.  But that day will come.  Since they’re at least a half-century behind in terms of investing.  What would be the first thing that you would tell the Chinese person who wants to invest in the U.S.?  What should they do with their money when they’re making their initial investment outside.

Charlie: Well, you’ve made an assumption I don’t follow.  If I were a Chinese person of vast intellect, talent,  discipline, all the good qualities…I would invest in China, not the United States.  I think the fruit is hanging lower there.  And some of the companies are more entrenched.  So I don’t agree with your proposition.  I think they have a tendency to think, ‘we were backwards therefore when we get rich, we should go over and invest in America.’  I think it’s always a mistake to look for a pie in the sky when you’ve got a big piece of pie right in your lap.  And so if I were…at current prices, I think an intelligent person would do better investing in China.

Question 31: You’ve said, everyone should spend 10-20% on some big ideas.  What are one or two big ideas that you are talking about. Meaning, specialize, but spend time working on some big ideas.

Charlie: Well the big ideas, I think you should be intelligent in improving yourself.  You’re way better to take on a really big important idea that comes up all the time than some little tiny idea that you might not face.  I always tried to grab the really big ideas in every discipline.  Because, why piddle around with the little ones and ignore the big ones.  Just all the big ideas in every discipline are just very, very, very useful.  Frequently, the problem in front of you is solvable if you reach outside the discipline you’re in and the idea is just over the fence.  But if you’re trained to stay within the fence you just won’t find it.  I’ve done that so much in my life it’s almost embarrassing.  And it makes me seem arrogant because I will frequently reach into the other fellows discipline and come up with an idea he misses.  And when I was young it caused me terrible problems.  People hated me.  And I probably shouldn’t have been as brash as I was.  And I probably wouldn’t be as brash as I am now.  I haven’t completed my self-improvement process.  But, it’s so much fun to get the right idea a little outside your own profession.  So if you’re capable of doing it, by all means learn to do it.  Even if you just want to learn it defensively.  I do not observe professional boundaries.  My doctor constantly writes, PSA test, prostate specific antigen, and I just cross it out. And he says, ‘What the hell are you doing?  Why are you doing this?’  And I say, ‘Well I don’t want to give you an opportunity to do something dumb.  If I’ve got an unfixable cancer that’s growing fast in my prostate I’d like to find out 3 months in the future, not right now.  And if I got one that’s growing slowly, I don’t want to encourage a doctor to do something dumb and intervene with it.  So I just cross it out.’  Most people are not crossing out their doctor’s prescriptions, but I think I know better. I don’t know better about the complex treatments and so forth.  But I know it’s unwise for me to have a PSA test.  So I just cross it out.  I’m always doing that kind of thing.  And I recommend it to you when you get my age.  Just go cross out that PSA test.  Now the women I can’t help.

Question 32A: How would you invest in a money manager you like?  Through a limited partnership, that would flow through the taxes, and the other way is through a corporation that would pay taxes on the gains and the dividends.  So basically, the corporation would serve no other function though than paying taxes.  So I think you’d be crazy to say that those two ways are equally desirable. (Charlie interjects)

Charlie: You’re certainly right about that.  It’s plumb crazy, and it’s exactly the way people who buy Berkshire are investing.  It’s plumb crazy to have a big common stock portfolio in a corporation and pay taxes compared to a partnership that doesn’t.  And that’s just the way the Berkshire shareholders have invested and they have made, whatever it is, 25% a years since we were there.  But you’re right, it’s not the logical way to do it.

Question 32B: So my question is, if you have to decide, to invest in pool A or pool B, how would you decide on what method you would use to figure out what discount would make you indifferent to whether you would invest in the corporate tax-paying structure when it flows to the… (Charlie interjects)

Charlie: I think it is totally asinine to invest in a portfolio of common stocks through a corporate taxed under the internal revenue code under sub chapter c or something.  It’s totally asinine.  At Berkshire, the public securities keep going down and down as a percentage of the total value, so it doesn’t matter, we’re getting to be sort of a normal corporation.  But I don’t think anybody’s right mind should invest through a corporation in a puddle of securities.  In fact the disadvantage is so horrible.  And so, I wouldn’t even consider it.  In other words…and I regard it as a minor miracle that we were able to get where we did.  So of course you’d invest in a partnership.

Question 33C: So when anyone who invests in Berkshire has to decide the discount to put on a pool of securities that has a future tax lien on the gains…do you have any mental model for…

Charlie: Yeah, my model is to avoid it.  We don’t want to invest in a portfolio of securities in somebody else’s corporation.  You’re totally right.  Which you already knew by the way.

Question 34: What’s your new findings of China?  Also, what’s your take on Ray Dalio’s statement that the U.S. election could unleash a new animal spirit which could lead to a better U.S. economy?  Do you buy this theory?

Charlie: Well, I’m not sure I understood that completely, but I’ll do my best.  What I like about China is that they have some companies that are very strong and still selling at low prices.  And the Chinese are formidable workers and they make wonderful employees.  There’s a lot of strength in that system.  And the Chinese government really tries to help its businesses, it is not behave like the government of India which I don’t think runs it’s country right at all.  And so, that’s what I like about China.  Or course I have to admire taking a billion and half people in a state of poverty up that fast.  That was never done in the history of the world.  And I admire the…you go to China and all the bullet trains go right to the heart of the city…what they’ve done is just an incredible achievement.  And they’ve done it not by borrowing money from Europe the way we did when we came up.  They have taken a poor nation with a lot of poverty and what they did is save half their income when they were poor and drive their nation way up with a lot of deferred gratification.  So it was unbelievably admirable and unbelievably effective.  So I admire that part of the Chinese picture.  China has one problem.  The problem with the Chinese people is they like to gamble and they actually believe in luck.  Now that is stupid.  What you don’t want to believe in is luck, you want to believe in odds.  And China there’s some reason in the culture, too many people believe in luck and gamble.  And that’s a national defect.

Question 35: If the world changes a lot in my lifetime, by the time I’m closer to your age, what do you think will not change about what makes a good successful business?

Charlie: What will not change is that it won’t be that damned easy.  There will be lots of…people will die that you love.  You’ll have close breaks where it goes against you.  There’s a lot of trouble that’s sure to come.  And at the end you’ll know that it’s all over, and that’s the game.  It’s a very funny game when you know when you start you have to lose.  See a dog doesn’t have to do that.  We know from the start we can’t win.  (Somebody) said the law of thermodynamics ought to be restated.  You can’t win, you must lose and you can’t get out of the game.  So we all face this ultimate difficultly. But once you’ve accepted the limitations, you’ve got the problem, how to get through your allot and expand reasonably well.  And I don’t think that’s that hard to figure out.  Because if you do pretty well, considering what you started with an so forth.  And you stand at the end and you’ve done credibly, you’ve helped other people who needed help because you had the capacity and intelligence to do it, and so on, and so on.  Set a reasonable example.  It’s a pretty good thing to do and it’s quite interesting.  And the difficulties make it interesting.

And something else happens that is really weird.  We were talking about, in our director’s meeting that proceeded this meeting, you always get glitches in something as complicated as a new software program going into a big new area.  And you suddenly have reverses and troubles and you’re scrambling.  And what I said is, that I’ve noticed in a long lifetime that the people who really love you, are the people where you scramble together with difficulty and you’ve jointly gotten through.  And in the end, those people will love you more than somebody whose just shared in an even prosperity through the whole thing.  So this adversity that seems so awful when you’re scrambling through, actually is the sinew of your success, your affection, every other damn thing.  And if you didn’t have the adversity you wouldn’t have the bonds which are so useful in life that are going to come from handling adversity well.  The idea that life is a series of adversities and each one is an opportunity to behave well instead of badly is a very, very, good idea.  And I certainly recommend it to everybody in the room.  And it works so well in old age because you get so many adversities you can’t fix.  So you better have some technique for welcoming those adversities.

Question 36: Do you believe that the 0,6, 25 high watermark fees structure that the Buffett Partnership popularized is the fairest structure for both limited partners and the manager themselves?  And what fee structure did you employ during your partnership.

Charlie: Well, I did copy the Buffett formula more or less, and I do think it’s fair and I think it’s still fair.  And I’m looking at Mohnish who still uses it.  I think it is fair and I wish it was more common.  I basically don’t like it where they’re just scraping it off the top.  If you’re advising other people, you ought to be pretty rich pretty soon.  Why would I take a lot of advice from somebody who couldn’t himself get pretty rich pretty soon?  And if you’re pretty rich why shouldn’t you put your money alongside your investors?  And go up and down with them.  And if there’s a bad stretch, why should you scrape money off the top when they’re going down enough?  So I like the Buffett system.  But it’s like so many things I like, it’s not spreading very much.  My net influence in the world, even Warren’s, has been pretty small.  Imagine how much copying we have in our executive compensation methods.  It’s about three examples.  Yes, I think it’s a fine system.

Question 37A: You spoke earlier about natural gas and the shipping of natural gas, and that activity…  (Charlie interjects)

Charlie: If I were running the world as a benign despot, I wouldn’t be shipping any natural gas outside of the United States.

Question 37B: So to tap into that view, you’ve been active in two states big in agriculture, Nebraska and California produce.  What are your thoughts on the agriculture industry and subsidies?

Charlie: Well the interesting thing about agriculture is what’s happened in my lifetime.  Which is the productivity of land has gone up about 300%.  And if it weren’t for that there would be a lot of starvation on earth.  The ag. system is one of the most interesting things that has happened in the last 60 or 70 years.  And we literally tripled the (productivity) of the land.  And we did it all over the world.  And there was just a few people who did it, the Rockefellers, Borlaug, and so forth.  It was one of the most remarkable things in the whole history of the earth and we need another doubling, and we’re probably going to get it.  And it’s absolutely incredible how well we’ve done.  And it’s amazing how efficient our farmers are.  We don’t have much socialization in farming.  We’ve got a bunch of people who own the farms and manage them themselves.  There’s not much waste and stupidity in farming.  Now people complain that we’re using up the top-soil, which I think we are, and I think that’s more of a mistake.  I would fix that if I were a benign despot.  Leaving aside using up the topsoil too fast, I think farming is one of the glories of civilization.  So I think it’s been wonderful what’s happened in farming.

Now in terms of subsidies.  It matters to the farmers where they get their subsidies.  And there’s no question about the fact that we’ve protected our farmers with subsidies and the farmers we’re protecting are getting richer and richer because the farms are owned by fewer and fewer people.  Own more and more acres per person.  So it’s very peculiar that we’re subsidizing people who are already filthy rich, to use up our topsoil a little faster.  And create stuff which we turn into ethanol.  Which is one of the stupidest ideas the world ever…you know I’m a specialist in stupid ideas (links: 1,2), but I would say turning corn into gasoline is about stupid an idea.  I would almost rather jump out of a 20 story building and think I could fly than turn corn into motor fuel.  It’s really stupid.  And yet that’s what our politics does.  I’ve got no cure for the stupidity of politics.  If I (did) the world it would be quite different.  I think that’s pretty minor whether we have subsidies or not.  The main thing that’s happening that has enabled the present population of the world to stay alive is this agricultural revolution and this very good managing of our farmlands.  And the improving agricultural standards in the rest of the world.  It’s gone on quietly that we’ve hardly noticed it.  How many of you are just deeply aware of the fact that grain per acre has gone up by 3 or 4 hundred percent.  That’s a huge stunt.  And by the way, if you take those miracle seeds and don’t use hydrocarbons, the yields are lousy.  We’re feeding ourselves because we know how to turn oil into food.  That’s one of the reasons I want to hold onto the oil.  Something that can be turned into food is quite basic.  And so I don’t mind conserving the oil instead of producing every last drop as fast as one can.  It’s odd that my idea hasn’t spread to more of people.  I may have three or four other people who agree with me in this room.  But you’re a bunch of admirers, and in the rest of the world, I’m all alone. (laughter)

Question 38: You’ve talked on emotions, discipline, and facing adversity.  Can you flesh out more about the spiritual side of this.  How you deal with the struggles and life.

Charlie: Well, just because you don’t have a specific theology, and I don’t…you know when I was a little kid and my grandfather sent me to Bible school and they told me there was a talking snake in the Garden of Eden?  I was very young but I didn’t believe them.  And I haven’t changed.  It doesn’t mean I am not spiritual, it’s just, I don’t need a talking snake to make me behave well.  And I would say that the idea that came down to me, partly through my family, was that rationality is a moral duty.  If you’re capable of being reasonable, it’s a moral failure to be unreasonable when you have the capacity to be reasonable.  I think that’s a hair-shirt that we should all take on, even if we’re pretty stupid.  Because it’s good to be less stupid.  So I think rationality is a moral duty.  And we all have a duty to get better.  And of course we also have to adjust to the other people who are going through our journey with.  I think it would be crazy not to have a social safety net when you’re as rich and successful as we are.  Now I don’t think it has to be as dumb as the one we have, but of course we need a solid social safety-net.  And it’s a moral idea.  So I’m all for morality…without the talking snakes.

Question 39: What are your thoughts on the MLP structure?  And do you have any preliminary thoughts on the border adjustment tax?

Charlie: Let me take the last question first.  We do not know what the boarder adjustment tax is.  I don’t think the people proposing it know what it is.  And I don’t think Trump and the Republicans in Congress have agreed on anything.  So I think we’re just talking about…But do I think some deep revision of the tax system might be a really good idea?  The answer is ‘yes’.  Do I think we should rely on consumption tax more?  The answer is ‘yes’.  Do I really care if somebody piles up a lot of money and leaves it to some foundation.  That’s not my idea of a big evil.  If they do want to live high on their private airplanes and their three hundred dollar dinner checks, I’m all for taxing the people who are living high.  So I like the idea of bigger consumption taxes.  And I think there’s a lot to be said for a different kind of a tax structure.

Question 40: You highlighted this idea of ‘deferred gratification’ a lot today.  In what areas of life is it most valuable?  And where should you enjoy things now vs. grind away and invest in the future?

Charlie: Well, I don’t think you should use up your body by being stupid in handling it.  And I don’t think you should be stupid in handling your money either.  And I think there are a lot of things where the only way to win is to work a long time towards a goal that doesn’t come easily.  Imagine becoming a doctor.  That is a long grind.  All those night shifts in the hospital and so and so on.  It’s deferred gratification.  But it’s a very honorable activity being a doctor.  By and large our doctors are very nice people and they’ve been through a lot.  I tend to admire the life of a doctor more than I admire the life of a derivatives trader.  And I hope all of you do.  And I think deferred gratification in the way our doctors behave is a very good thing for all the rest of us.

Question 41: Question about the circle of competence.  How do you know its limits.  And does it get redrawn from time to time.  Does it always expand, or does it contract?

Charlie: Well of course you know some things that aren’t so, and of course if you’re dealing with a complex system, the rules of thumb that worked in the complex system in year 1 may not work in year 40.  So in both cases it’s hard.  The laws of physics you can count on, but the rules of thumb in a complex civilization changes as the civilization changes.  And so you have to live with both kinds of uncertainty and you have to work longer.  It’s not a bad thing.  It’s interesting.  We’re all the same here…who would want to live in a state of sameness, you might as well be dead.

Wall Street Journal Recap: January 17-22, 2017

My full notes and analysis on the Wall Street Journal from the past week: January 17-22, 2017 (Week 3).  Please Enjoy.

Buffett & AIG

AIG paid Berkshire Hathaway $10 billion to bring “stability to their balance sheet” and gives them “greater certainty”.  (link)

Meanwhile, Warren Buffett has said, “We pay a high price for certainty.”  Howard Marks added to this comment, “People who want to buy bargains should prefer uncertainty.”

Translation: AIG paid a high price and Buffett got a bargain.

China & Autocatalytic Reactions

China’s economy achieved yet another year of “stable” GDP growth, but their growth comes at the expense of increasing disorder everywhere else in their economy.  This type of behavior is known as an “autocatalytic reaction.”, which is a mental model that I now use to think about China’s economy.

Autocatalytic Reaction: “Order can be created in a system by an even greater decrease in order of the systems surroundings…The order of the Earth’s atmosphere increases, but at the expense of the order of the sun. The sun is becoming more disorderly as it ages and throws off light and material to the rest of the universe.” (wikipedia)

China creates GDP Stability at the expense of Economic Chaos everywhere else.  Below are examples of China’s autocatalytic economy in action.

“GDP Stability”

  1. IMF Raises Growth Forecast for U.S. Economy (link)

“(China) is laboring to keep growth chugging along…the government used its long-worn playbook of state policies to stimulate growth.”

  1. China Hits Growth Goal On Big Does of Stimulus (link)

“Beijing is expected to double down on old growth drivers this year – including fiscal spending and the property market- to keep the economy stable in an important year of leadership change.”

“Beijing posted the lowest annual growth in a quarter-century, and economists say it only got there by relying heavily on short-term measures that are likely to delay much-needed reforms to bloated state-owned companies and the country’s inefficient financial system.”

“Economic Chaos”

  1. A Risky Twist on Repo Trade in China (link)

These “dai chi” agreements are outrageous…Used to temporarily move funds around in order to skirt government audits, as well as take on more risk.  Doesn’t this sound familiar to AIG and credit default swaps?

“A little-regulated practice that companies have used to borrow hundreds of billions of dollars and move risky assets temporarily off their book.”

“The risk is that dai chi agreements tend to be informal and often don’t leave a paper trail.”

“These transactions, by one estimate, may easily top $1 Trillion in value.  The practice is just one of the many unexpected risks that have sprouted up in China’s long credit boom.”

China’s credit boom has “helped send Chinese bond prices to a 14 year high in mid-August and pumped up markets for everything from iron ore to garlic.”

“Traders say the deals are so opaque that even estimates are hard to make.”

Banks sometimes use the dai chi agreements to move risky assets temporarily off their books during earnings periods or audits, the people said.  Brokers like Sealand typically use them to borrow quickly and flexibly-leveraging their investments many times over,”

  1. Copper Tethered to Dollars’ Moves (link)

Chinese investors are grasping for any investments to get their money out of China or the Yuan.  As a result, they are creating volatile and unusual behavior in Copper prices, among other asset classes.

“Metals and other commodities that are priced in dollars tend to fall when the dollar appreciates…But copper and the dollar have been moving nearly in lockstep recently, a phenomenon that many analysts attribute to rising appetite for copper among Chinese investors seeking to protect their wealth against the risk of a sharp Yuan depreciation against other global currencies, primarily the dollar.”

“In November, the correlation between copper and the WSJ Dollar Index reached its highest level since 2007.”

“In five hours on one day, we say (copper) prices trade in a range that would normally take a year” to play out.

  1. Bitcoin Trading Faces Greater Scrutiny in China (link)

China is trying to limit the ability of Chinese individuals and companies to move their wealth abroad, a trend that contributes to a depreciating Chinese yuan and risks destabilizing the broader financial system.”

Trump & China

If Trump stops China from dumping highly subsided products into our markets (link), I think he’ll unintentionally destroy the lynch-pin holding together China’s economy…highly subsidized factories.

To give more detail to this picture, this is what I imagine much of China’s economy looks like:

  1. China’s local governments fund themselves by land sales and real estate development. But the land is only valuable if there are people and jobs.
  2. The easiest way to create jobs is to subsidize industries which can generate LOTS of jobs, like steel production. Steel production creates jobs in mining, transportation, energy, engineering, and of course factory workers.
  3. With lots of people working, or soon to be working, demand for real estate skyrockets. This in turn creates more jobs because workers are needed to build all this new real estate.
  4. It might be ok if only a few cities in China used this model, but I believe this to be pervasive. As a result, China is creating WAY too much steel and other products.  With an oversupply of subsidized goods, they must dump them into U.S., and global markets for whatever prices they can get.

If the Trump administration stops China from dumping its highly subsidized products into the U.S., subsidized factories all over China will quickly implode and take entire cities with it.  Being so highly leveraged, China is not in a position to handle the impact of such an event.

This of course is just my hypothesis, and I welcome any disconfirming evidence.

“Retail Meritocracy” & Deteriorating Moats

It feels like we’ve entered a new area that I’d like to call “retail meritocracy”.  Brand names use to serve an important role in signaling both value and quality to consumers.  But with easy access to internet reviews and scores, brand name goodwill seems to be rapidly deteriorating for many companies.

Luxottica appears to be a good example.  Luxottica has a dominant position in the old world distribution and marketing platform of sunglasses and eyewear.  In this old model, floor space and brand names served as a solid barrier to entry.  But there’s been a trend towards commoditization of sunglasses and eyewear as consumers become more comfortable with buying off-brand names like Warby Parker.  Online reviews, ratings, etc. have weakened Luxottica’s competitive moat.

  1. Merger to Create Eyewear Giant (link)

“The merger joins two companies that previously risked stepping on each other’s toes as Luxottica expanded into lens manufacturing and Essilor moved into frames…both companies could shrink because of a harsher price competition for frames and lenses.”

  1. Why Golfers Covet the Costco Ball (link)

In another example of “retail meritocracy”, Kirkland brand golf balls became a hot selling items when it was discovered that they perform nearly as good as Titleist Pro VI golf balls.  “This is just a perception killer,”  The Kirkland golf balls retailed for $1.25/ball, while Pro VI’s retailed for ~$4/ball.

We  have entered a time of retail meritocracy where many brand-name-moats are being eroded more quickly than anticipated.

Know what’s being measured

It’s important to know what’s being measured.  Sometimes we forget.  Here are some examples:

  1. Private Prison Industry Gets Boost From Election (link)

A likely example of lying with statistics.

The DOJ found that private prisons were more dangerous than government-run facilities.

“Contractors criticized the report, saying it compared private and government-run prisons even thought they house different types of criminals.”

“The private facilities are dominated by lower-security, illegal immigrants who have committed crimes, a demographic in which gangs are prevalent.”

  1. Rocky Route for Rail Line (link)

“If you cut 30 minutes off, I’d be for it,”

Note: Nowhere in his comment does this frequent Amtrak traveler consider the $120 billion cost.

  1. Fed Officials Shift focus on Growth (link)

When the Fed and U.S. Government talk about the success of their economic programs they largely speak of 1) an increase in overall demand and 2) a reduction in unemployment.  When they say the economy is “healed”, they are likely measuring it by overall demand and unemployment numbers.

Global Growth Fuels Netflix Surge (link)

“The streaming video giant has prioritized growth over profit as it pursues its international rollout”

Success is being measured by user growth…which is the same metric used by Netflix’s competitors.  All of its competitors are foregoing profits for revenues

Oops! When Little Errors = Big Mistakes.

Two examples of little mistakes that lead to big errors.

  1. Student-Debt Picture Darkens (link)

The U.S. government WAY underestimated how many students have “defaulted on or failed to pay back their college loans.”

Previous numbers “overstated repayment rates for 99.8% of all colleges and trade schools in the country.”

“The new analysis shows that at more than 1,000 colleges and trade schools, or about a quarter of the total, at least half the students had defaulted or failed to pay down at least $1 on their debt within seven years.”

In 2015, the reported number was 347 colleges.  Today it stands at 1,029.

  1. Afghan Payroll Cut in Corruption Fight (link)

The U.S. military was paying 30,000 Afghan soldiers that didn’t exist!  That came out to $13 million per month.  Now, the U.S. military will only pay Afghan soldiers who were biometrically enrolled in the nation’s army.

The Growth Promise

Why does it seem that troubled companies always insist upon expanding into growth markets?  Why are they so eager to grow a business model with fundamental problems?  Examples include:

  1. Pearson Drops as Future Darkens (link)

“Pearson said its revenue fell 30% in the fourth quarter making for a full-year decline of 18% that it called unprecedented.”

“…which has put pressure on Pearson’s business even as it seeks new sources of growth in emerging economies such as Brazil and China.”

  1. Can Revlon Regain Some of Its Lost Luster? (link)

“One way Mr. Garcia intends to lessen Revlon’s reliance on the U.S. is by entering China.”

I’m Curious. Is this an Accounting Illusion, Real, or Both?

Railroad Mavrick Buoys Investors (link)

I’m curious about this case.  I wonder if Mr. Harrison’s operating efficiencies are real or are merely accounting related.  After all, he’s able to do what no one else in the industry is capable of doing, which should raise some questions.

“Each time the message was similar: Mr. Harrison has proved himself able to cut costs and improve operations and is a better executive than you current team.”

 Irrational Exuberance

On the backs of the second longest bull-market in history, artificially low interest rates have created intense competition among investors for any yield whatsoever.  Furthermore, ultra-low interest rates have incentivized land-lords not to sell, which has reduced supply and intensified competition further.

  1. Texas Billionaires Joined to Strike Deal (link)

Plano Texas’s raw land has gone from $8 to $10 a square foot a few years ago to $60 today.  Due to growing appeal to corporate tenants.

“The property attracted the attention of about 40 investors.”

Ultimately it was won by the investor able to secure a high loan to equity ratio.

It’s unusual for an investor group to be able to borrow such a high percentage of a deal’s value, as Mr. Ware’s group did.

Participants said it worked because the bank will get an equity like return if the group hits the “jackpot” with the new leasing and land development.

  1. Investors Pump In Cash But Supply Is Lacking (link)

Investors piling money in: “Investors are piling money into real estate funds, but fund managers are finding it challenging to spend it.”

Hunt for returns in an Ultra low interest rate environment: “The record level of dry powder comes as investors increasingly have turned to commercial real estate in a hunt for returnsUltra low interest rates at global central banks have made returns on offices and shopping malls look attractive compared with other asset classes such as bonds.

On par with 2005 to 2008: “Global fund managers have raised $446 billion for commercial property in the past four years, on par with the total raised from 2005 to 2008 in the run-up to the global financial crisis,”

Fierce competition for few properties: “With competition for deals fierce, “it has been much more challenging to invest,”…”There are very few forced sellers,”

Landlords aren’t willing to sell.  Their low debt levels and readily available bank financing have made it easy to hold on to properties longer in hopes of reaping bigger paydays later,”

Increasing demand: Deflation & Inflation

  1. ‘Rideables’ Could Curb Car Ownership (link)

Increased demand can have either an inflationary effect or a deflationary effect.  Which way it goes is largely dependent upon two factors:

1) The speed at which supply can expand to meet demand and

2) economies of scale.

In the case of electric vehicles, increasing demand has had a deflationary effect:

“…the rapid expansion of the market has led to demand for parts, making them in turn cheaper and more available, much like what happened with mobile phones.”

“batteries are getting cheaper at 4% to 8% a year, and that compounding over the last five years has had a massive impact” on the electronic-vehicle industry.

Meanwhile, increasing demand has had an inflationary effect on price of oil and gas service providers (link).

Significant Housing Developments

  1. Mortgage Lending Shift Spurs Worry Over Risk (link)

There’s been a big shift in the FHA lending market for single-family mortgage market over the past 10 years.

Topped $1 trillion:Bonds backed by certain risky single-family mortgages topped $1 trillion for the first time in November, crossing that threshold amid warnings about that corner of the U.S. housing market.”

Banks have all but stopped participating: “The result: In the first three quarters of 2016, banks accounted for 9% of mortgage dollars originated by the FHA’s top 50 lenders, versus 62% for all of 2010, according to Inside Mortgage Finance. Nonbank lenders accounted for 80% of mortgage bonds backed by single-family FHA loans in July 2016, versus 9% the same month in 2010…This is the biggest shift in mortgage lending since the savings-and-loans debacle in the 1980’s.”

“It’s too costly to originate”: “J.P. Morgan Chase & Co., the nation’s largest bank by assets, isn’t among the 50 largest FHA lenders.  In 2013, it was the third largest,”…”It simply is too costly and too risky to originate these kinds of mortgages,” Jamie Diamon wrote.

FHA share of the mortgage market has tripled: the FHA share of the overall mortgage market is larger than during the last housing boom.  In the years leading up to the housing bust, FHA loans accounted for less than 5% of annual mortgage volume.  Since the meltdown, the share has ranged from 11% to 15% of originations.

FHA loans under Ginnie Mae has Quadrupled since 2007: “That growth has boosted the amount of bonds Ginnie Mae backs. The $1 trillion of outstanding FHA single-family loans in November that it guaranteed compares with $272 billion at the end of 2007. Overall, Ginnie Mae now backs more than $1.7 trillion in bonds, which includes loans backed by other agencies such as the Department of Veterans Affairs as well as the FHA.”

Nonbank lending creates market risks: “The funding issue arises because nonbanks don’t hold deposits. So they rely on short-term financing, often from banks, mostly to originate new loans. That can dry up in stressed times.”

As Power Changes Hands, HUD Makes Swift Move (link)

The Trump administration seems likely to curb large housing affordability programs which make mortgages more accessible to lower income families, but at the same time distort free market dynamics.  This would likely put downward pressure on home prices.

Challenges Lurk in the Economy (link)

“The U.S. home ownership rate is near a 50-year low, and the average debt load for college students is rising.”

The Confidence Illusion

There’s a lot of certainty and confidence going on.  Investors are feeling much more confident, the fed is feeling much more confident, consumers are feeling much more confident, etc.  But should we trust them?  Caution would be the prudent advice.

The article, “Don’t Let Others Sway You When Making Investment Decisions” (link), points out that we can be heavily influenced by people with an intense belief in ignorant views.

“We’re biologically equipped with the potential to allow more-confident people to have greater sway over our own beliefs,”

“In a paper published in 2000, Prof. Shiller showed that confidence varies, often going up after the market rises and falling after it goes down.  The confidence of individual investors rose 4% in July 2008, for instance, right before the market got sucked into the black hole of the financial crisis.

“So you could visualize the stock market as a poltergeist or hobgoblin who takes a twisted delight in play pranks on the expectations of the investing public.”

1. Treasury Yields Resume Ascent (link)

Janet Yellen is viewing things positively.

“In a speech Thursday at Stanford University, Ms. Yellen said she doesn’t see the U.S. economy at risk of overheating and doesn’t expect growth to pick up much soon,”

But be careful to give too much weight to her comments.  Remember that after the financial crisis, Alan Greenspan wrote:

“In the run-up to the crisis, the Federal Reserve Board’s sophisticated forecasting system did not foresee the major risks to the global economy.  Nor did the model developed by the IMF, which concluded as late as the spring of 2007 that “global economic risks [had] declined” since 2006 and that “the overall U.S. economy is holding up well…[and] the signs elsewhere are very encouraging.” (link)

Service Providers with High Fixed Costs

  1. For Shale Drillers, Rising Oil Prices Also Come With Rising Costs (link)

Interesting story for a case study:

During a dramatic drop in oil prices, oil & gas companies get a sort of mini-bailout by their service providers.  These service providers effectively absorb some of the losses from oil & gas companies, thereby shielding them and making the decline more manageable.

But the effect is a two-way street.  When oil price rebound, service providers are quick to raise prices and dampen the benefits of rising prices.

Why does this happen?

The service providers have high fixed costs.  Upon declining oil prices, oil & gas companies cut demand for their services.  Because service providers have high fixed costs, they will continue to provide services at a loss, sometimes just as long as their variable costs are covered.

I believe you could say that, to some extent, the fixed costs of your service providers or suppliers act as a shield in bad times.  They will/must lower their service fees,  thereby making the hard times more tolerable.

What should we learn from this?

1) We should look at service providers and suppliers and determine the level of their fixed costs and variable costs.

2) Oil & Gas companies should really position themselves better to take advantage of a decline in oil prices.

Before the decline in oil & gas prices, the whole industry had positioned themselves aggressively.  When the crash came, no company was in a position to exploit the lower costs offered by service providers.  Or buy oil assets at discounted prices.

Instead, they all waited for a rebound in prices to start working again, at which point, they completely missed out on compelling market opportunities.

The problem with that strategy is that it’s hard to do.  But as Charlie Munger says, “It takes character to sit there with..cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.”

Government Corruption & Lee Kuan Yew’s Advice

  1. Scandal Rocks Samsung (link)

“(President Park Geun-hye) was impeached last month over allegations that her confidante, Choi Soon-sil, sought to shake down the country’s biggest conglomerates for donations in exchange for political favors.”

There’s just so much corruption being exposed in governments around the world right now.  If you’re interested in learning more about the roots of corruption and how to stop it, I suggest reading the chapter “Keeping the Government Clean” from Lee Kuan Yew’s book, “From Third World to First”.  Here are a few great quotes:

“Human ingenuity is infinite when translating power and discretion into personal gain.” – Lee Kuan Yew

“A precondition for an honest government is that candidates must not need large sums of money to get elected, or it must trigger off the cycle of corruption.  The bane of most countries in Asia has been the high cost of elections.  Having spent a lot to get elected, winners must recover their costs and accumulate funds for the next election.  The system is self-perpetuating.” – Lee Kuan Yew

The Best Investment Quote of All Time is from…Napoleon?

Could the best investment quote of all time come from Napoleon?  Quite possibly.  It was in the unlikely place of Napoleon Bonaparte’s personal diary that I found one of the best investment passages I’ve read.  Bursting with investing wisdom, it would be understandable to mistake Napoleon for Warren Buffett.  Although he’s writing about the art of war, the insights apply to investing just as well.

Interpretation

Below I dissect Napoleon’s journal entry to ascertain its valuable investing insights.

Importance of mathematics & probabilities:

To be a good general a man must know mathematics; it is of daily help in straightening one’s ideas.  Perhaps I owe my success to my mathematical conceptions

Beware of forecasts.  Buffett & Munger don’t invest in a company if they can’t see its strength displayed through history:

a general must never imagine things, that is the most fatal of all.

Eliminate psychological biases & crude heuristics which skew one’s perception of reality:

My great talent, the thing that marks me most, is that I see things clearly;

Identify the main issues and ask the right questions:

it is the same with my eloquence, for I can distinguish what is essential in a question from every angle.

Practice Bayesian updating:

The great art in battle is to change the line of operations during the course of the engagement; that is an idea of my own, and quite new.

Keep it simple. Stick to the fundamentals and common sense: 

The art of war does not require complicated maneuvers; the simplest are the best and common sense is fundamental.  From which one might wonder how it is generals make blunders; it is because they try to be clever.  The most difficult thing is to guess the enemy’s plan, to sift the truth from all the reports that come in.  The rest merely requires common sense;

Stay curious.  Do a lot of reading & research lots of companies.  Eventually you’ll come across a good idea: 

it’s like a boxing match, the more you punch the better it is.

Know how to read financial statements: 

It is also necessary to read the map well.”

“La victoire appartient aux plus persévérants.”

Investment Lessons from a Master Sushi Chef

The best investment book I read this year didn’t come from a Wall Street whiz or hot shot finance professor, rather it came from Jiro Ono, a Master Sushi Chef. Yes, “the Jiro”, the one from the acclaimed documentary “Jiro Dreams of Sushi.”

While in Japan this past September I picked up his book titled “Jiro Philophosy” and was quite surprised. Unlike most investment books, Jiro doesn’t talk about investing at all. In fact, it isn’t even an investment book. Rather Jiro Philosophy simply describes Jiro’s personal work-ethic.

2016-12-17-19-25-01As I read this book, I quickly came to realize just how closely Jiro’s philosophy mirrors that of Warren Buffett, Charlie Munger, and Ben Graham. It was quite surprising to see that the same principles which lead to mastery in Sushi can also lead to mastery in investing.

As a result, I have distilled the book “Jiro Philosophy” down to its 12 core principles and relate each one to the investment philosophy of Buffett, Munger, and Graham.

1. Stick to the fundamentals. Stay grounded.

Jiro

If you stray from the fundamentals – say, trying to set yourself apart from other chefs – you will completely stray off track.  I believe that by adhering to the fundamentals and continuously striving to create delicious flavors, you will be able to be innovative.”

“If you continue to do things the right way, it’s a given that your sushi will turn out delicious.” 

Investing

stick-to-the-fundamentalsMarket manias and bubbles all have two things in common;  an abandonment of fundamental investment principles and an endless series of rationalizations.

Ben Graham understood the immense rationalization power of markets very well.  He experienced it first hand during the lead up to the great depression.  It was his understanding that as markets move higher, investors don’t become more reserved, but rather they invent knew valuation metrics to justify paying any price whatsoever.  As been Graham observed, “We can find no evidence that…investors as a class have sold their holdings because PE ratios were too high.”

Consequently, Ben Graham developed an immutable investment philosophy based on strict fundamental analysis to keep investors from “completely straying off track”.  And much like Jiro Ono, investors who have stuck to Ben Graham’s fundamentals of investing have delivered “delicious” results.

With this, I’m reminded of Lou Manheim ‘s advice to Bud Fox in the movie Wall Street, “Stick to the fundamentals…good things, sometimes take time.”

2. Gain Mastery.

Jiro

“You’ve got to master some skills to reach the next stage.”

“You won’t advance to the next level all on your own.  You need to train properly up to a certain point.  In the case of Jiro, after a decade of training, a craftsman will have mastered everything from preparation to making sushi.  He will be ready to strike out on his own.”

Investing

Warren Buffett pursued and achieved mastery over Ben Graham’s investment philosophy before advancing to the next level.  Warren’s path to mastery took on the following steps:

  • Discovered Ben Graham’s book “The Intelligent Investor” at the age of 19.
  • Read Graham’s 700+ page book, Securities Analysis, at least 12 times.  
  • Attended Columbia so that he could study under Ben Graham.
  • Worked for Ben Graham at his investment fund.
  • Invested using Ben Graham’s investment principles at the Buffett Partnership.

3. Put Knowledge into Practice.

Jiro

“People will teach you new things and ideas, but if you don’t try them out you will not change.”

“No matter how good the teaching, unless you actually put it into practice, you won’t be able to progress.  You will only have the knowledge.  People passionate about their work are always trying to improve upon what they’ve made.  It’s enjoyable and rewarding.”

“Because of this, we can keep trying new things every day.”

Investing

Throughout his life, Warren Buffett has shown an amazing willingness and ability to put knowledge into practice.   This includes applying the teachings of Ben Graham as well as the four hour educational interview he had with GEICO executive Lorimar Davidson in 1950.

Much of Warren’s success simply boils down to seeking out the best knowledge and putting it into practice.  Warren recommends you do the same thing:

“You need to fill your mind with various competing thoughts and decide which make sense. Then you have to jump in the water – take a small amount of money and do it yourself. Investing on paper is like reading a romance novel vs. doing something else. You’ll soon find out whether you like it. The earlier you start, the better.”

4. Improve upon what you’re taught.  Otherwise you will always be an apprentice.

Jiro

“Just doing as you’re taught is the same as being an apprentice.  I tell my young apprentices that they should think about how to achieve good flavor on their own, improve it and then experiment.  I always tell them if they don’t, they will be apprentices for life.”

Investing

Although Warren Buffett began his career as Ben Graham’s apprentice, he did not simply stick to his teaching.  Rather he modified and improved upon Graham’s teachings over time.  As Charlie Munger describes it:

“If we’d stayed with the classic Graham, the way Ben Graham did it, we would never have had the record we have. And that’s because Graham wasn’t trying to do what we did.”

5. Practice Beginner’s Mind. (Shoshin)

Shoshin (初心) is a concept in Zen Buddhism meaning “beginner’s mind“. It refers to having an attitude of openness, eagerness, and lack of preconceptions when studying a subject, even when studying at an advanced level, just as a beginner in that subject would. (Wikipedia)

Jiro

screen-shot-12-17-16-at-07-37-pm“That said, once they’ve become independent they should still pursue improvement just like an apprentice.

“Feeling you can still evolve is important.”

Investing

Both Warren Buffett and Charlie Munger are enthusiastic learners who enjoy the process.  In fact, Charlie has said that he and Buffett are “dissatisfied with what they know.”  As a result, they are always seeking to learn, adapt, and evolve.

Charlie further explains the importance of this mindset,

“Warren Buffett has become one hell of a lot better investor since the day I met him, and so have I. If we had been frozen at any given stage, with the knowledge we had, the record would have been much worse than it is. So the game is to keep learning, and I don’t think people are going to keep learning who don’t like the learning process.”

6. The way you do the small things reflects how you do the big things.

Jiro

Through Jiro’s Philosophy, he stresses the importance of the small things.  From cleanliness, to hot towels, to the preparation process, rice, etc.  All the smallest details are given the greatest care.  The way you do the small things reflects how you do the big things.

Investing

Likewise, Buffett has a keen eye for detail as displayed by the following two stories:

Story 1:

Buffett also liked Cathy’s attention to detail.  “When I asked her on the phone how many employees she had, she replied ‘504.’  I love this,” said Buffett.  “Not ‘about 500.’ I think she has 505 now and is doing considerably more business.  She won’t be happy until she has 100 percent market share.”  (From the book “The Women of Berkshire Hathaway: Lessons from Warren Buffett’s Female CEOs”)

Story 2:

The following is an excerpt from the Q&A session at the 2016 Berkshire Hathaway Annual Meeting:

Warren Buffett: Yes, sloppy thinking in one area probably indicates there may well be sloppy thinking elsewhere. I have been a director of 19 public corporations. I’ve seen some very sloppy operations and I’ve seen a few really outstanding business operators, and there’s a huge difference. If you have a wonderful business, you can get away with being sloppy. We could be wasting a billion Dollars a year, at Berkshire, you know $640m after tax, that would be four percent of earnings, and maybe you wouldn’t notice it….

Charlie Munger: I would.

Warren Buffett: Charlie would notice it… It’s the really prosperous companies that well….the classic case were the tobacco companies many years ago. They went off into this thing and that thing, and it was practically play money because it was so easy to make. It didn’t require good management, and they took advantage of that fact. You can read about some of that in ‘Barbarians of the Gate’.

7. Listen to good advice.

Jiro

“I take customers’ advice when it makes sense.”

“Even when you think you are right often that’s not the case.  No matter what kind of business you are in, if you only work in an inflexible way, you won’t find success.”

“If (a customer’s advice) makes sense, I will adopt it, otherwise I will never evolve.”

Investing

Warren Buffett and Charlie Munger have exhibited an open mind and willingness to listen to good advice throughout their careers.  In fact, if it weren’t for some timely advice they might not have bought See’s Candies.  As Charlie Munger recounts,

“[Munger’s friend] Ira Marshall said you guys are crazy — there are some things you should pay up for, like quality businesses and people. You are underestimating quality. We listened to the criticism and changed our mind. This is a good lesson for anyone: the ability to take criticism constructively and learn from it. If you take the indirect lessons we learned from See’s, you could say Berkshire was built on constructive criticism.

8. Preserve your main asset…You.

Jiro

screen-shot-12-17-16-at-07-50-pmIn his 40’s, Jiro recognized that his most critical asset as a Sushi Chef was the sensitivity in his finger tips.  As a result, he began wearing gloves in order to preserve the long-term integrity of his hands.  

This might seem like a mildly trivial matter, but for anybody looking to achieve and maintain success in their profession, follow Jiro’s example: Identify the physical or mental attribute that is necessary for success in your field and take measures to preserve it.

Investing

Warren Buffett identifies the most important trait of an investor as “emotional stability”.  As Warren explains,

“To be a successful investor, you don’t need to understand higher math or law. It’s simple, but not easy. You do have to have an emotional stability that will take you through almost anything. If you have 150 IQ, sell 30 points to someone else. You need to be smart, but not a genius. What’s most important is inner peace; you have to be able to think for yourself. It’s not a complicated game.”

Similar to Jiro’s practice of wearing gloves to protect his hands, here are some routines and strategies which Buffett uses to maintain emotional stability, inner peace, and independent thought.

  • An alert and fresh mind: 
    • Warren gets good sleep and takes naps when necessary
    • He plays bridge many hours every week.
  • A temperament uncorrupted by outside influences:
    • He Lives in Omaha
    • Maintains a Clear Schedule
    • Keeps a quiet office where he can think.
  • Health:
    • “My diet, though far from standard, is somewhat better than usually portrayed. I have a wonderful doctor who nudges me in your direction every time I see him. All in all, I’ve enjoyed remarkably good health — largely because of genes, of course — but also, I think, because I enjoy life so much every day.”

Furthermore, Warren explains the importance of preserving and enhancing yourself through life:

“Imagine that you had a car and that was the only car you’d have for your entire lifetime. Of course, you’d care for it well, changing the oil more frequently than necessary, driving carefully, etc. Now, consider that you only have one mind and one body. Prepare them for life, care for them. You can enhance your mind over time. A person’s main asset is themselves, so preserve and enhance yourself.”

9. Be a craftsman. Pursue work to satisfaction.

Jiro

“Pursuing work to satisfaction is the pride of a craftsman.  No matter how time consuming, I will leave no task to others.  I will do them all myself until satisfied.  Even as I get older, I still do all the work, even if it’s bothersome.  I feel very pleased when I develop and create something from a new idea of my own.”

Investing

Likewise, Buffett takes pleasure in doing all the investment analysis himself.  He does not have a team of analysts working for him.

10. Be passionate about what you do.

Jiro

“People who love their work passionately want to continue working.  I’m no exception.  Although I’m 90 years old, I’d like to keep on going.  That’s why I don’t find investing time in my work troublesome.”

Investing

At 86 years old, Buffett still tap-dances to work.  He derives great enjoyment from researching different companies.  He compares it to researching different species of animals.

11. Adapt to changing circumstances.

Jiro

screen-shot-12-17-16-at-07-41-pm“Since all sushi toppings are changing, sushi craftsman must now factor this in when working out flavors.”

“The oceans are quickly changing.  For example, the season for katsuo (skipjack tuna) now starts six months later.  But we have to serve the best of what’s in season.  Fish and shellfish were tastier in the past and it is difficult to find their intense flavors.  The next generation of sushi chefs will face challenges in trying to find ways to bring out and enhance fish flavors.”

Investing

Likewise, in investing you cannot wish for something which doesn’t exist.  You must play the hand that you’re dealt.

When Warren Buffett started investing, he could find net-net investments everywhere.  But the investment ocean quickly changed and he had to adapt to the circumstances.  Over the years, Buffett has invested in a broad range of investment classes including, bonds, common equity, preferred stock, warrants, options, commodities, and special situations.  He doesn’t wish for something that doesn’t exist, rather he adapts himself to whatever asset is on sale below his intrinsic value.

At the same time, Warren will never abandon his core principles and rationalize new investments.  During the “Nifty 50” stock market, he declared that he couldn’t find any cheap stocks and refused to invest.  Later Buffett refused to invest in tech stocks during the tech boom of the 90’s.  In each case Warren has been rewarded for his patience and sticking to the fundamentals.

This leads to a crucial point.  Although you must adapt to changing environments, you must also remember to stay true to the fundamentals.  As it says in rule number 1, “If you stray from the fundamentals…you will completely stray off track.”

So remember: Adapt, but do not abandon.

12. It’s never too early to prepare

Jiro

“It’s never too early to prepare.  You can start preparation way in advance.”

Jiro began working at a local restaurant from the age of seven.

Investing

Likewise, Warren Buffett recalls his youthful experience: “By the age of 10, I’d read every book in the Omaha public library about investing, some twice.”

Furthermore, Buffett said he read the 10Ks of IBM for fifty years before ultimately making an investment in the company.  That’s fifty years of “preparation.”

Jiro Philosophy: Distilled

jiro-philosophy

Haiku Review: Deep Value by Tobias Carlisle

Inspired by a recent trip to Japan, here are my 7 main insights distilled from Deep Value by Tobias Carlisle, in Haiku form.  Arigatou gozaimasu.

Japanese Painting

1. Risk: “A Bundle of Twigs Cannot Easily Be Broken”

Stocks perceived risky,

Find resilience when bundled.

Have fewer down years.

2. Return: Buy the “Ugliest of the Ugly”

Deep Value defies

Investment Intuition.

Ugly is Better.

3. Trust in Mean Reversion & Avoid Naive Extrapolation

Trust Mean Reversion.

Naive Extrapolation

Ignores the Base Rate.

4. Expand Your Time Horizon

Seeking to avoid

Short-term underperformance,

They’re captured by it.

5. Behavioral Biases: Your Intuition is Killing You

Three Crude Heuristics,

Lead us to poor decisions.

What feels right is wrong.

6. Use a Statistical Approach: Focus on Simple & Effective Techniques

Ben Graham’s approach:

Stick to a few Techniques and

Simple Principles.

7. Stay out of the Way: Overconfidence Leads to Reduced Performance

Our judgment misleads,

We find broken legs abound.

Stay out of the way.

number 7 japanese

Deep Value’s 7 Main Takeaways

Deep Value by Tobias Carlisle reads somewhat like an investment version of “Mom’s” classic question, “If your friends jumped off a cliff, would you?”  Wall Street is filled with people jumping off cliffs and the people who follow.  The question is, why would so many people consistently invest in a way that’s bad for their well-being?  The answer lies largely within the errors of our intuition.  Carlisle warns that, often times, “the incorrect decision feels right, while the correct decision feels wrong.”

If our investment intuition is so often wrong, then the first step to becoming a better investor should be to recognize that we are naturally wired to jump off investing cliffs.  The next step involves giving counter-intuitive ideas a chance.   After all, as Einstein said, “The definition of insanity is to keep trying the same thing while expecting a different result.”  Insanity in this case, is relying on our intuition to help us make wise investment decisions.deep-value-tobias-carlisle-6

Consequently, we can view Deep Value as a sort of counter-intuitive survival guide to overcoming our self-destructive investment tendencies.  (aka “How to stop jumping off of cliffs”)

Next to here you will find the summary of my seven main takeaways from Deep Value.  Please feel free to print it out and re-read these points whenever your intuition tries to lead you off a cliff.

Risk:” A Bundle of Twigs Cannot Easily Be Broken”

Within traditional finance, risk is commonly defined as “the currency by which we pay for returns”.  Meaning that if we want higher returns, we must bear greater risk.  This intuitively makes sense if the markets are efficient.  But Deep Value discredits this intuitive assumption.

Throughout the book, Carlisle focuses on two groups of stocks that exist at the opposite ends of the spectrum.  Value Stocks and Glamour Stocks.  Value stocks are considered risky investments.  They are typified as companies that you wouldn’t want to own.  They are often down and out companies that exist in unfavorable industries and have poor prospects.  Meanwhile, glamour stocks are considered safe investments.  These are companies that generally have high returns on capital, seemingly endless growth prospects, exist in favorable industries, and are widely admired. (i.e. companies you’d love to own)

On an individual basis, value stocks are indeed the riskier prospect.  Value Stocks, as defined here as net-nets, lose 90% or more in a single year 5% of the time, versus only 2% of the time for all stocks.

But the nature of value stocks changes dramatically when they are bundled together.  In fact, they have fewer down years than the market.  In a study, net-net stocks only had 3 down years in 26 versus 6 down years for the market.

This investment phenomena mirrors a quote by Tecumseh, Native American leader of the Shawnee.  He said, “A single twig breaks, but the bundle of twigs is strong.”  A value stock by itself is like a twig that easily breaks, but finds strength when bundled together.

twig-analogy

Return: Buy the “Ugliest of the Ugly”

If value stocks have less risk than glamour stocks, then traditional finance states that they should have lower returns.  But yet again, Carlisle proves this notion to be wrong.  In fact, he shows that value stocks generate superior returns to their riskier glamour stock counterparts.

Deep Value presents many studies which show that returns for value stocks are significantly greater than glamour stocks.  But perhaps most surprising is Carlisle’s case that the ugliest stocks provide the best returns.  The nature of this counter-intuitive element is steeped in Behavioral Finance.  Everyone in their pursuit of safety, shun companies that look risky, which creates bargains.

The ugliest of the ugly phenomena extends to countries as well.  The countries with the poorest recent performance outperform countries with the best recent performance.

solitude-poemThis investment bias towards glamour and value stocks is perfectly capture by a poem I encountered by Ella Wheeler Wilcox titled Solitude.  In it she wrote, “Be glad, and your friends are many; Be sad, and you lose them all”.

Furthermore, this poem explains why value investing is a successful strategy.  The very nature of investing in value stocks is contrarian because you’re willing to do what very few will.  Value Investors immerse themselves in grief, woe, gall, fasting, and pain.  As a result of these counter-intuitive actions, value investors  get counter-intuitive returns.

Put another way, value investors get pleasurable returns for hanging around companies in sorrow.  While typical investors get sorrowful returns for hanging around companies in pleasure.

Trust in Mean Reversion & Avoid Naive Extrapolation

Deep Value contrasts two starkly different predictive assumptions about the future.  The most commonly used assumption is naive extrapolation, whereby the past performance of a company is extrapolated out into the future.  The less commonly used assumption is mean reversion, whereby a company’s financial performance will  eventually revert towards the mean.

Carlisle demonstrates that, of the two methods, investors should rely on mean reversion.  The importance of mean reversion should not be understated.  Ben Graham identified mean reversion as the phenomenon that leads value strategies to beat the market.   Furthermore, Carlisle writes, “An appreciation of mean reversion is critical to value investment.”

Mean Reversion is built upon a fundamental economic truth that;

  1. Competition naturally eats away at high returns over time. “In most cases competition and other corrective forces work on the highly profitable business to push its return back to the mean.”
  2. Low returns will more often than not, revert towards the mean. “Stocks with big market price losses and historically declining earnings tend to see their earnings grow faster, and outperform the market.”

On the other hand, naive extrapolation makes the assumption that past results will generally continue undeterred into the future.  While this appears to be mathematically sounds, it ignores the “Base Rate”.  The Base Rate  shows that this simplifying assumption is not true for most companies.

As a results, predictions using naive extrapolation often disappoint, while predictions using mean reversion are the more likely outcome.  The chart below provides a good visualization of these two methods at work.

mean-reversion2

Mean reversion appears to have an element of Biblical faith to it.  It reminds me of a Bible Verse, Hebrews 11:1, which says, “Now faith is confidence in what we hope for and assurance about what we do not see.”  Likewise, value investors have confidence in what they hope for (anticipating mean reversion in both fundamentals and valuation) and assurances (base rate, invisible hand) about what they do not see.  Whereas most investors mistakenly invest based on what they see (historical figures), but shouldn’t expect (naive extrapolation).

Expand Your Time Horizon

To be a value investor, you must expand your time horizon.  Mean reversion often takes time.  In fact it can take 3-5 years, during which time, you may experience years of poor performance.  Most investors don’t have this kind of patience.  Wall Street generally isn’t kind to short-term underperformance.

Consequently, many fund managers will chase short-term performance at the expense of long-term success.  Quarter on Quarter and Year on Year is their focus.  But as Carlisle writes, “by attempting to avoid short-term underperformance, they are captured by it.”

Behavioral Biases: Your Intuition is Killing You

Behavioral Bias is really a dual sided topic.  First, you must understand the various Behavioral Biases which contribute to your poor investment decisions.  Secondly, you must recognize that even after understanding these biases, it remains difficult to overcome them.

Carlisle writes,

“Kahneman and Tversky found that we make decision about uncertain future events based on three heuristics…Each leads us to make poor decisions about uncertain events because it leads us to consider irrelevant evidence, and in so doing diverts us from considering the underlying probabilities about the events.”

The three biases as identified by Tversky & Kahneman are:

  1. Anchoring & Adjusting: Causes us to stick with our first impression, even when evidence arrives that conflicts with our view.
  2. Representativeness: We use stereotypes to make simplifying assumptions.
  3. Availability: Only consider things that are quickly brought to mind.

It has been shown that people still fall victim to these three biases despite working to prevent them.

“No matter how well trained we are, humans tend to have difficulty with probabilistic, uncertain, and random process.  Confronted with problems requiring an intuitive grasp of the odds in an unfamiliar context, even the best investors and behavioral finance experts flounder.  If mere awareness that our judgment is clouded by our nature does little to correct the errors we make, how then can we protect against them?

So then, what can we do about it?

Use a Statistical Approach: Focus on Simple & Effective Techniques

Carlisle offers a solution to this behavioral bias dilemma: Remove yourself from the equation.

You can accomplish this by using a statistical based approach.  Ben Graham found that the best investment approach is one that follows simple and effective techniques.

Tobias covers three value investing formulas in Deep Value which follow simple and effective techniques.  They are:

  1. Net-Nets by Ben Graham (http://www.libertyinvesting.com/benjamin-grahams-checklist/)
  2. The Magic Formula by Joel Greenblatt (www.magicformulainvesting.com)
  3. The Acquirer’s Multiple by Tobias Carlisle (http://acquirersmultiple.com/)

Net-Nets are excellent when you find them, but they are heavily exploited, illiquid, and there’s a limited opportunity set.  Meaning that you can’t grow the strategy beyond a certain size.

The Magic Formula attempted to derive Buffett’s investment strategy down into two elements, and has had great results.

  1. Quality of Business: ROIC = EBIT/(net working capital + net fixed assets).
  2. Attractive Price: Earnings Yield/Enterprise Value

The Acquirer’s Multiple, developed by Carlisle, is an evolution of the Magic Formula.  Carlisle finds that the Quality of Business element in the formula only serves to detract from overall returns.  He finds that the formula can simply be boiled down to “Attractive Price”, as defined as (Enterprise Value/Operating Earnings).

Stay Out of the Way

After Choosing your statistical approach, you may be tempted to alter the results using your subjective judgment, but this should be avoided.

self-reflexivity-2Carlisle demonstrates that the returns of the model are a ceiling from which we detract.  Not a base from which we add.  The reason being twofold:

  1. We are largely over-confident in our abilities.
  2. We find more broken legs than there really are.

In a sense, we want to de-correlate our thinking from that of the markets.  But when we introduce our subjective judgment, we begin using more intuition and thereby increase our correlation with the market.  Thus reducing returns.

Summary

The Deep Value strategy can be summarized in four steps:

  1. Create a simple & effective statistical model using counter-intuitive value investing insights, including mean-reversion.
  2. Remember, you are investing based on an expected group outcome, so don’t over-concentrate your portfolio in any one stock.
  3. Expand your time horizon to 3-5+ years.
  4. Recognize your limitations, and, for the most part, stay out of the way.

Despite many findings that demonstrate the soundness and relatively safe nature of a value portfolio, investment professionals largely shun value stocks.  The reason for their reluctance is largely centered around self-preservation.

Managers must defend their investments to clients who are usually emotional, impatient, and unsophisticated.  So if a manager invests in a group of poor companies which are undervalued, he’ll likely have to answer to his clients who see those investments as risky and imprudent.  Especially if there’s any prolonged period of underperformance.

On the other hand, it is much easier for a manager to appear prudent by simply investing in a portfolio of slightly overvalued glamour stocks that look safe.  Since the portfolio looks safe, clients will sleep well at night under the belief that the manager is acting prudently.  The manager too will sleep well because he has less stress and greater job security.  So be aware, appearances of prudence can be deceiving.

I recently came across an interview with Walter Schloss, the late great value investor, who gave an example of such a dilemma that he faced;

People have certain emotions, and they wanted to not lose money.  So we didn’t tell people what we owned, and one guy said, ‘You know Walter, I can’t stand it not knowing what we own.’  He was an old man, so I said, ‘Well we own some bankrupt bonds of the Pennsylvania Railroad.’  Which  actually turned out very well later, and he said, ‘I can’t be in your partnership knowing that, it makes me too upset.’  So he withdrew.  So people act emotionally, and if they know what you own, then they look at it and say, ‘Oh I don’t like that stock.’  Then they call you on the phone and say, ‘Well why do you own it?’  I don’t want to hear people complaining.  They trusted me with their money, and that’s what a lot of hedge funds do, they don’t disclose what they own.”