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Notwithstanding the wide coverage that Buffet received over the years, it appears that the real truth about value investing is still lost upon many. Buffet has developed an extraordinary track record of picking stocks, yet many continue to undervalue his process, so much that he feels the need to reinforce the tenets important to his success. Though we are by no means an expert on his writings, there are some tenets in Buffet's annual report to shareholders that we believe we should illuminate.
The 'Oracle of Omaha' needs no introduction, for he has done what most investors have not, and has attained global recognition in the process. His investment philosophy has been studied, and written about for decades, and such that there is a reservoir of accessible information about his investments. Notwithstanding the wide coverage, Buffet, after many letters and years of proven results still, rightfully so, feel the need to reinforce the tenets important to his superior returns. In our view, the truth behind his superior returns is still lost upon many. Though we are no expert on his writings, there are some tenets in Buffet's annual report to shareholders that we believe we should illuminate.
Over the period 1965 to 2017, if you had invested in Buffet's partnership (for those who would have been alive then) you would have grown your net-worth by an annual compounded rate of 19.1%, which is almost 10% percentage points above that of the S&P over the same period. Many of our readers would love to attain such extraordinary gains in net-worth and believe me when I say we are in the same boat. In this article, I will attempt to distill in simple terms, the tenets that have worked for us thus far, tenets which I believe have been shared in Buffet's letters over the years, and in his most recent piece. First, take a quick look at the chart below and you will see a couple of things. 1) Compounding your money consistently will have a huge impact on your net-worth over a long period of time, 2) Buffet's annual percentage gains between 1965 and 1998 are substantially larger than those after 3) As the scale of his portfolio increased, his percentage gains fell.
At the risk of over simplifying, we think the corner stone of Buffet's investment philosophy is buying, at some discount, entities where you can be at least 70% confident in the future cash flows they will produce. Buffet uses
the term earning power (EP) instead of cash flows, but they are similar concepts. Earning power in our minds is totally unrelated to the accounting earning per share (EPS) that is typically touted by analysts, investment bankers, and journalists.
Earning power in our minds is the earnings you can confidently say a company can sustain forever. Without getting too philosophical, we use the word entities to mean governments, and companies. Invariably, the predictability of cash flows
for government securities (Bonds in particular) is higher than that of companies, albeit there is still a degree of risk embedded. Countries don't die, but governments do go bankrupt.
This is where things get 'sticky'. In a world that is void of all emotions and personal biases, the value of all assets is based on the cash that they provide you, discounted by a rate that reflects the willingness of the average person to forgo consumption today, for some benefit in the future. We all know what that discount rate is, it is quoted in the papers daily, but what about future cash flows? How much do we know about cash flows, even if we assume the world is perfect? Early in my career, I went on a journey seeking to know more, more, and more, in a bid to understand the future better than most. In the process, l learnt how write code to process tons of data. Today, I can tell you that the more I learnt about the world, the more I realised that predicting cash flows is a near impossible task.
Without going into academic theories, think about a world where 7.6 Billion people are making decisions simultaneously, every minute, and every second of each day. Each decision they make affects the price of the assets you own, whether they are customers, suppliers, employees, or even friends of suppliers or of customers. We should be thankful that the decisions of the 7.6 billion people on this planet do not affect the value of our securities to the same degree every day. Nevertheless, over a 10 to 20-year period, it is likely that a significant portion of the 7.6 billion people will have an impact, especially in an increasingly globalized world. Even more concerning is that the 7.6 Billion people is projected to get to 11 Billion in the next decade.
Economists like to assume that people are rational, but let us go further, assume they are robots. For you to predict cash flows you would have to know what 7.6 Billion robots are doing every second of every day, plus know the spill off effects of their interaction for possibly trillions of permutations. Can you do that? Now add to this impossibility, the reality that people are: 1) not rational at all times, 2) not void of emotions, 3) have deeply embedded personal biases. This leads us to the unmistakeable truth, that it is very difficult to be right. In his letter, Warren Buffet explains the danger doing too much activity. When he said:
A final lesson from our bet: Stick with big, "easy" decisions and eschew activity. During the ten-year bet, the 200-plus hedge-fund managers that were involved almost certainly made tens of thousands of buy and sell decisions. Most of those managers undoubtedly thought hard about their decisions, each of which they believed would prove advantageous. In the process of investing, they studied 10-Ks, interviewed managements, read trade journals and conferred with Wall Street analysts. Prote?ge? and I, meanwhile, leaning neither on research, insights nor brilliance, made only one investment decision during the ten years. We simply decided to sell our bond investment at a price of more than 100 times earnings (95.7 sale price/.88 yield), those being "earnings" that could not increase during the ensuing five years.
We made the sale in order to move our money into a single security - Berkshire - that, in turn, owned a diversified group of solid businesses. Fueled by retained earnings, Berkshire's growth in value was unlikely to be less than 8% annually, even if we were to experience a so-so economy. After that kindergarten-like analysis, Prote?ge? and I made the switch and relaxed, confident that, over time, 8% was certain to beat .88%. By a lot.
In our view, activity in and of itself is not bad. It is that given the difficulty of the task at hand, if you are doing a lot of activity there is a 95% chance that you are making mistakes. In a good year, you will possibly find 2 investments where you can be very confident in the minimum future cash flows it will provide, let alone find these investments trading at a discount. Remember, buying a security above its discounted future cash flows is like donating some of your money to a non-charitable cause. Buying at a discount not only adds value to you if you turn out to be right, but also protects you should you turn out to be wrong. It is always good to bake into your assumptions that you will be wrong most of the time.
Hopefully we have convinced you that relying on your 'superior intelligence' is probably wrong. The best way to make money from the markets is to own businesses (as opposed to stocks) that can protect its own cash flows, through actions that its management can take at their leisure. Some companies may not be at that stage of development yet, but they must be heading in that direction for it to be considered a good investment (both stocks and bonds). At our holding company we refer to these features as strategic optionality. In Buffet's letter he mentioned these same tenets in much broader terms when he discusses his acquisition criteria. These tenets can also be deduced from the deals he did. Let us talk about what his acquisition criteria are first. In his 2017 letter he said:
In our search for new stand-alone businesses, the key qualities we seek are durable competitive strengths; able and high-grade management; good returns on the net tangible assets required to operate the business; opportunities for internal growth at attractive returns; and, finally, a sensible purchase price.
Again, at the risk of oversimplifying, all these criteria are there to serve one goal, which is to give you confidence in your future cash flow projections/earning power. The fact of the matter is that at every second of each day at least 40% of the 7.8 billion people on this planet are sharks looking to eat your business for dinner--taking some of your cash flow for themselves. Trust us when we say, if your business can't defend itself, at some point within your investment horizon you are going to become shark food. When that happens, your money will simply vanish into thin air, and your discount cash flow projection will have served one purpose -- that of maintaining Microsoft's cash flow. Additionally, purchasing at the right price is equally important, as we've said before purchasing at a high price is tantamount to donating your money. This fact makes your cashflow estimate even more imporant, as the right price is determined by your discount of the cash flows that you expect to receive.
Looking at the few investments that Buffet made during the year, we see certain themes that are consistent across his activities. Some of the themes are: scale (scale could also be a function of the size of his investment portfolio, scale nevertheless provides economic advantages to companies), dominant market positions, a management team with 'skin in the game', and having long term economic trends as your tailwind. According to the letter:
We were able to make one sensible stand-alone purchase last year, a 38.6% partnership interest in Pilot Flying J ("PFJ"). With about $20 billion in annual volume, the company is far and away the nation's leading travel-center operator. PFJ has been run from the get-go by the remarkable Haslam family. "Big Jim" Haslam began with a dream and a gas station 60 years ago. Now his son, Jimmy, manages 27,000 associates at about 750 locations throughout North America. Berkshire has a contractual agreement to increase its partnership interest in PFJ to 80% in 2023; Haslam family members will then own the remaining 20%. Berkshire is delighted to be their partner
On the bolt-on acquisition front, we see a focus on market share:
Clayton Homes acquired two builders of conventional homes during 2017, a move that more than doubled our presence in a field we entered only three years ago. With these additions - Oakwood Homes in Colorado and Harris Doyle in Birmingham - I expect our 2018 site built volume will exceed $1 billion
Clayton's emphasis, nonetheless, remains manufactured homes, both their construction and their financing. In 2017 Clayton sold 19,168 units through its own retail operation and wholesaled another 26,706 units to independent retailers. All told, Clayton accounted for 49% of the manufactured-home market last year. That industry-leading share - about three times what our nearest competitor did - is a far cry from the 13% Clayton achieved in 2003, the year it joined Berkshire.
For the Shaw Industries case, the focus seems to be on the long term opportunities in housing, and the ability to consolidate the market:
Near the end of 2016, Shaw Industries, our floor coverings business, acquired U.S. Floors ("USF"), a rapidly growing distributor of luxury vinyl tile. USF's managers, Piet Dossche and Philippe Erramuzpe, came out of the gate fast, delivering a 40% increase in sales in 2017, during which their operation was integrated with Shaw's. It's clear that we acquired both great human assets and business assets in making the USF purchase.
For the case of home services, you can infer the market structure the company is operating in. If Buffet acquired the third largest and the 14 largest operators, yet still have only a 3% markets share, it means that the industry is quickly becoming oligopolistic:
I originally paid little attention to HomeServices. But, year-by-year, the company added brokers and, by the end of 2016, HomeServices was the second-largest brokerage operation in the country - still ranking, though, far behind the leader, Realogy. In 2017, however, HomeServices' growth exploded. We acquired the industry's third-largest operator, Long and Foster; number 12, Houlihan Lawrence; and Gloria Nilson. With those purchases we added 12,300 agents, raising our total to 40,950. HomeServices is now close to leading the country in home sales.... Despite its recent acquisitions, HomeServices is on track to do only about 3% of the country's home- brokerage business in 2018. That leaves 97% to go. Given sensible prices, we will keep adding brokers in this most fundamental of businesses.
Another consistent theme you would notice throughout the letter is that he believes that housing at this moment remains a great long-term investment opportunity. Virtually all his large bolt-on acquisitions are connected with the housing supply chain, from tiles and floorings, to broker dealers, to manufactured homes. Thus far the reported growth in these areas have been astounding.
There are many other lessons to learn from Warren Buffet's letter. Today, we simply took the themes that stood out to us. We encourage you to read it for yourself as investing is as much personal as it is business. At KPB & Co we focus on the predictability of cash flows, you may be able to read it and glean some other message that we didn't cover, if you do please share.