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I write about the theory and practice of investing and in doing so I try to take a value investing approach. You can follow me here on twitter: https://twitter.com/nomeansum
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No Mean Sum
  • Grand Master Buffett - Part 5  0 comments
    Feb 7, 2013 8:17 PM

    Almost universally, the first lesson in an introductory finance course attempts to imbue in investors the concept of opportunity cost. And indeed it should be as it is one of the most fundamental ideas in both economics and investing. But after you learn to approximate the risk-free rate discount rate, the concept is usually shuffled into to some dusty corner your mind. This was no less the case for me until I read the following passage by Mr. Buffett:

    The Chairman's Letter - 1984

    Washington Public Power Supply System

    From October, 1983 through June, 1984 Berkshire's insurance
    subsidiaries continuously purchased large quantities of bonds of
    Projects 1, 2, and 3 of Washington Public Power Supply System
    ("WPPSS"). This is the same entity that, on July 1, 1983,
    defaulted on $2.2 billion of bonds issued to finance partial
    construction of the now-abandoned Projects 4 and 5. While there
    are material differences in the obligors, promises, and
    properties underlying the two categories of bonds, the problems
    of Projects 4 and 5 have cast a major cloud over Projects 1, 2,
    and 3, and might possibly cause serious problems for the latter
    issues. In addition, there have been a multitude of problems
    related directly to Projects 1, 2, and 3 that could weaken or
    destroy an otherwise strong credit position arising from
    guarantees by Bonneville Power Administration.

    Despite these important negatives, Charlie and I judged the
    risks at the time we purchased the bonds and at the prices
    Berkshire paid (much lower than present prices) to be
    considerably more than compensated for by prospects of profit.

    As you know, we buy marketable stocks for our insurance
    companies based upon the criteria we would apply in the purchase
    of an entire business. This business-valuation approach is not
    widespread among professional money managers and is scorned by
    many academics. Nevertheless, it has served its followers well
    (to which the academics seem to say, "Well, it may be all right
    in practice, but it will never work in theory.") Simply put, we
    feel that if we can buy small pieces of businesses with
    satisfactory underlying economics at a fraction of the per-share
    value of the entire business, something good is likely to happen
    to us - particularly if we own a group of such securities.

    We extend this business-valuation approach even to bond
    purchases such as WPPSS. We compare the $139 million cost of our
    yearend investment in WPPSS to a similar $139 million investment
    in an operating business. In the case of WPPSS, the "business"
    contractually earns $22.7 million after tax (via the interest
    paid on the bonds), and those earnings are available to us
    currently in cash. We are unable to buy operating businesses
    with economics close to these. Only a relatively few businesses
    earn the 16.3% after tax on unleveraged capital that our WPPSS
    investment does and those businesses, when available for
    purchase, sell at large premiums to that capital. In the average
    negotiated business transaction, unleveraged corporate earnings
    of $22.7 million after-tax (equivalent to about $45 million pre-
    tax) might command a price of $250 - $300 million (or sometimes
    far more). For a business we understand well and strongly like,
    we will gladly pay that much. But it is double the price we paid
    to realize the same earnings from WPPSS bonds.

    However, in the case of WPPSS, there is what we view to be a
    very slight risk that the "business" could be worth nothing
    within a year or two. There also is the risk that interest
    payments might be interrupted for a considerable period of time.
    Furthermore, the most that the "business" could be worth is about
    the $205 million face value of the bonds that we own, an amount
    only 48% higher than the price we paid.

    This ceiling on upside potential is an important minus. It
    should be realized, however, that the great majority of operating
    businesses have a limited upside potential also unless more
    capital is continuously invested in them. That is so because
    most businesses are unable to significantly improve their average
    returns on equity - even under inflationary conditions, though
    these were once thought to automatically raise returns.

    (Let's push our bond-as-a-business example one notch
    further: if you elect to "retain" the annual earnings of a 12%
    bond by using the proceeds from coupons to buy more bonds,
    earnings of that bond "business" will grow at a rate comparable
    to that of most operating businesses that similarly reinvest all
    earnings. In the first instance, a 30-year, zero-coupon, 12%
    bond purchased today for $10 million will be worth $300 million
    in 2015. In the second, a $10 million business that regularly
    earns 12% on equity and retains all earnings to grow, will also
    end up with $300 million of capital in 2015. Both the business
    and the bond will earn over $32 million in the final year.)

    Our approach to bond investment - treating it as an unusual
    sort of "business" with special advantages and disadvantages -
    may strike you as a bit quirky. However, we believe that many
    staggering errors by investors could have been avoided if they
    had viewed bond investment with a businessman's perspective. For
    example, in 1946, 20-year AAA tax-exempt bonds traded at slightly
    below a 1% yield. In effect, the buyer of those bonds at that
    time bought a "business" that earned about 1% on "book value"
    (and that, moreover, could never earn a dime more than 1% on
    book), and paid 100 cents on the dollar for that abominable
    business.

    If an investor had been business-minded enough to think in
    those terms - and that was the precise reality of the bargain
    struck - he would have laughed at the proposition and walked
    away. For, at the same time, businesses with excellent future
    prospects could have been bought at, or close to, book value
    while earning 10%, 12%, or 15% after tax on book. Probably no
    business in America changed hands in 1946 at book value that the
    buyer believed lacked the ability to earn more than 1% on book.
    But investors with bond-buying habits eagerly made economic
    commitments throughout the year on just that basis. Similar,
    although less extreme, conditions prevailed for the next two
    decades as bond investors happily signed up for twenty or thirty
    years on terms outrageously inadequate by business standards.
    (In what I think is by far the best book on investing ever
    written - "The Intelligent Investor", by Ben Graham - the last
    section of the last chapter begins with, "Investment is most
    intelligent when it is most businesslike." This section is called
    "A Final Word", and it is appropriately titled.)

    We will emphasize again that there is unquestionably some
    risk in the WPPSS commitment. It is also the sort of risk that
    is difficult to evaluate. Were Charlie and I to deal with 50
    similar evaluations over a lifetime, we would expect our judgment
    to prove reasonably satisfactory. But we do not get the chance
    to make 50 or even 5 such decisions in a single year. Even
    though our long-term results may turn out fine, in any given year
    we run a risk that we will look extraordinarily foolish. (That's
    why all of these sentences say "Charlie and I", or "we".)

    Most managers have very little incentive to make the
    intelligent-but-with-some-chance-of-looking-like-an-idiot
    decision. Their personal gain/loss ratio is all too obvious: if
    an unconventional decision works out well, they get a pat on the
    back and, if it works out poorly, they get a pink slip. (Failing
    conventionally is the route to go; as a group, lemmings may have
    a rotten image, but no individual lemming has ever received bad
    press.)

    Our equation is different. With 47% of Berkshire's stock,
    Charlie and I don't worry about being fired, and we receive our
    rewards as owners, not managers. Thus we behave with Berkshire's
    money as we would with our own. That frequently leads us to
    unconventional behavior both in investments and general business
    management.

    We remain unconventional in the degree to which we
    concentrate the investments of our insurance companies, including
    those in WPPSS bonds. This concentration makes sense only
    because our insurance business is conducted from a position of
    exceptional financial strength. For almost all other insurers, a
    comparable degree of concentration (or anything close to it)
    would be totally inappropriate. Their capital positions are not
    strong enough to withstand a big error, no matter how attractive
    an investment opportunity might appear when analyzed on the basis
    of probabilities.

    With our financial strength we can own large blocks of a few
    securities that we have thought hard about and bought at
    attractive prices. (Billy Rose described the problem of over-
    diversification: "If you have a harem of forty women, you never
    get to know any of them very well.") Over time our policy of
    concentration should produce superior results, though these will
    be tempered by our large size. When this policy produces a
    really bad year, as it must, at least you will know that our
    money was committed on the same basis as yours.

    We made the major part of our WPPSS investment at different
    prices and under somewhat different factual circumstances than
    exist at present. If we decide to change our position, we will
    not inform shareholders until long after the change has been
    completed. (We may be buying or selling as you read this.) The
    buying and selling of securities is a competitive business, and
    even a modest amount of added competition on either side can cost
    us a great deal of money. Our WPPSS purchases illustrate this
    principle. From October, 1983 through June, 1984, we attempted
    to buy almost all the bonds that we could of Projects 1, 2, and
    3. Yet we purchased less than 3% of the bonds outstanding. Had
    we faced even a few additional well-heeled investors, stimulated
    to buy because they knew we were, we could have ended up with a
    materially smaller amount of bonds, purchased at a materially
    higher price. (A couple of coat-tail riders easily could have
    cost us $5 million.) For this reason, we will not comment about
    our activities in securities - neither to the press, nor
    shareholders, nor to anyone else - unless legally required to do
    so.

    One final observation regarding our WPPSS purchases: we
    dislike the purchase of most long-term bonds under most
    circumstances and have bought very few in recent years. That's
    because bonds are as sound as a dollar - and we view the long-
    term outlook for dollars as dismal. We believe substantial
    inflation lies ahead, although we have no idea what the average
    rate will turn out to be. Furthermore, we think there is a
    small, but not insignificant, chance of runaway inflation.

    Such a possibility may seem absurd, considering the rate to
    which inflation has dropped. But we believe that present fiscal
    policy - featuring a huge deficit - is both extremely dangerous
    and difficult to reverse. (So far, most politicians in both
    parties have followed Charlie Brown's advice: "No problem is so
    big that it can't be run away from.") Without a reversal, high
    rates of inflation may be delayed (perhaps for a long time), but
    will not be avoided. If high rates materialize, they bring with
    them the potential for a runaway upward spiral.

    While there is not much to choose between bonds and stocks
    (as a class) when annual inflation is in the 5%-10% range,
    runaway inflation is a different story. In that circumstance, a
    diversified stock portfolio would almost surely suffer an
    enormous loss in real value. But bonds already outstanding would
    suffer far more. Thus, we think an all-bond portfolio carries a
    small but unacceptable "wipe out" risk, and we require any
    purchase of long-term bonds to clear a special hurdle. Only when
    bond purchases appear decidedly superior to other business
    opportunities will we engage in them. Those occasions are likely
    to be few and far between.

    In nothing I've read can I recall opportunity cost extended so as to compare asset clases themselves. At least some of this reluctance can be attributed to the differences in structure between bonds and fixed income; equities enjoy greater protection from inflation, and bonds are higher in the capital structure, so in theory the comparison is not apples to apples. But Buffett isan't dealing with theory here; he is doing the real thing, and finding that whatever the problems exist for an infinitive comparison of stocks and bonds, from an in the trenches perspective, the framework has real utility.

    Perhaps the most striking aspect of this passage is how comfortable it feels. Here Buffett is investing in high yield securities (junk bonds) which he readily acknowledges carry the distinct possibility of not only default but the potential erosion of his purchasing power from inflation as well. And yet, couched in the logic of what I would term this bonds as a business perspective, he seems almost giddy at the opportunity to have made such a wager.

    With hindsight it is tempting to say, "This is Buffett, he made a great bet, of course he's happy! If I was as smart as him, I would write happy letters about the smart bets I made too!" However, it seems to me that to take such a perspective is both wrong and foolish, as it assumes that the principal driver of performance is some innate intelligence comparable to IQ, and that there is nothing to learn from the great investors who have come before us. Instead, I think it is both more useful and more accurate to view his performance, and his relative comfort with risk as deriving from his process, his investment philosophy if you will. Which is not to say that anyone can replicate Buffett; the breadth and depth of his prowess, his knowledge in investing is, for my money unequaled. But rather that by careful examination of his record, we can discern the platform by which he leveraged his innate abilities and employ it to similar benefit in our own practice.

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