Buffett's Underrated Investment Attribute

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Includes: FMCC, SHLDQ
by: John Huber

A few weeks ago, Sears (OTCPK:SHLDQ) finally filed for bankruptcy, and I decided to read through some of my notes I've compiled over the years on that company. During this review, I came across a couple old posts that I wrote on the topic of circle of competence:

As I recently mentioned, I think one of Warren Buffett's most underrated skills is his ability to recognize when a situation is getting outside of his well-defined circle of competence. He not only recognizes when a situation is too hard, but I think he doesn't waste much time even considering the investment. I doubt he spent more than an hour thinking about whether or not to invest in Sears when Lampert reorganized the retailer in the early 2000s. I'll highlight a few comments Buffett made in 2005 when asked about Sears. What strikes me is the common sense and simplicity of his logic:

"Every day retailers are constantly thinking about ways to get ahead of what they were doing the previous day…

"Retailing is like shooting at a moving target. In the past, people didn't like to go excessive distances from the street cars to buy things. People would flock to those retailers that were nearby. In 1966 we bought the Hochschild Kohn department store in Baltimore. We learned quickly that it wasn't going to be a winner… We had an antiquated distribution system. We did everything else right. We put in escalators. We gave people more credit. We had a great guy running it, and we still couldn't win. So we sold it around 1970. That store isn't there anymore. It isn't good enough that there were smart people running it.

"We would rather look for easier things to do. The Buffett grocery stores started in Omaha in 1869 and lasted for 100 years. There were two competitors. In 1950, one competitor went out of business. In 1960 the other closed. We had the whole town to ourselves and still didn't make any money.

"How many retailers have really sunk, and then come back? Not many. I can't think of any. Don't bet against the best. Costco is working on a 10-11% gross margin that is better than the Walmart's and Sams'. In comparison, department stores have 35% gross margins. It's tough to compete against the best deal for customers."

It's not that Buffett was certain that Lampert couldn't turn it around, it's just that he thought it would be extraordinarily difficult. I think one of Buffett's key strengths is not just passing on these types of long-shots, but also doing so in such a quick manner. I don't think he wastes much time or spends much mental energy at all with these kinds of ideas. He'll miss some turnarounds that turn into big winners, but he's not bothered by that. He simply chooses to focus on the more certain bets, and seemingly has no trouble resisting everything else.

One thing that is interesting about Buffett is how very few major errors there are on his record. I think this stems from his incredible ability to say no, and the even more impressive ability to change his mind when he realizes he is wrong. He has exhibited this on numerous occasions. Two recent examples are when he sold IBM and Tesco (OTCPK:TSCDF), the British grocer.

Selling Freddie Mac

An example that is even more significant, in my opinion, is when he decided to sell Freddie Mac (OTCQB:FMCC) in 2001. As I mentioned in the previous post, I've done a lot of reading lately on Fannie (OTCQB:FNMA) and Freddie, out of interest and curiosity (not out of anticipation of making an investment in their securities, as I think the company is likely to remain in the purgatory-like state of government conservatorship until there is some sort of shock that upsets the status quo).

Regardless of their future, they are really interesting companies to study. Thanks to CNBC's excellent website on Buffett (which includes the transcripts of each Berkshire (BRK.A, BRK.B) annual meeting going back to 1995), I was able to go back and read everything Buffett said on the GSEs. I wanted to know what he was thinking when he decided to sell Freddie Mac in 2001.

Basically, as I outlined in my last post, Fannie and Freddie had two main businesses: they collected a fee for guaranteeing mortgages, and they earned a spread between the interest they earned on their own portfolio of mortgages and their cost of funds.

In short, Buffett became uncomfortable with the size of Freddie's ever-expanding mortgage portfolio and noticed a few red flags (why was Freddie Mac buying RJR bonds? What does the junk debt of a cracker company have to do with providing liquidity to the housing market?).

I also read through Buffett's comments on the financial crisis that he made in front of the FCIC in 2010, and one sentence summarized his views on Freddie a decade prior: "I just figure that when you see a cockroach, there are more hiding."

Being Honest With Yourself

The main point of this post has nothing to do with Freddie Mac or Sears specifically, but rather, the remarkable ability Buffett has to change his mind when he realizes he is wrong. Buffett seems to have the temperament and personality which allow him to easily overcome the typical biases that haunt most investors. There are many types of biases associated with investments that you currently own, including the so-called "endowment effect", where you tend to view more favorably the positions you already own. This can cause you to overlook, ignore, or de-emphasize problems that are becoming evident with one of your holdings. In addition to overcoming this bias, Buffett also avoided getting trapped by his previous public stance on Freddie Mac, which was obviously a stock and a company that he spoke about positively on many previous occasions, as Berkshire was the largest shareholder at one time.

He was honest with himself about what he saw developing in Freddie Mac's mortgage portfolio, and he was very willing to change his mind once he recognized the budding risks that made him uncomfortable.

I think this point - intellectual honesty - is another one of Buffett's most underrated traits as an investor. This goes hand in hand with his ability to stay within his circle of competence, but the reason he is so successful at staying within his circle of competence is because he is honest with himself about what it is that he knows and what it is that he doesn't know.

I think the vast majority of investment mistakes can be traced back to the inability to be honest about your own knowledge or level of understanding about a subject matter. It's hard for smart people who have spent their lives being right far more often than they are wrong to admit to themselves that something is too challenging. It is even harder to admit that their original assessment was completely wrong.

So, I think intellectual honesty can be a source of a powerful edge for those who can harness it to their advantage. I recently highlighted this point in a post I wrote about Li Lu.

To Sum It Up

I think it's remarkable how quickly and easily Buffett was able to avoid what appeared to be an interesting situation that was so popular at the time in the investing community. I think part of the reason it was so easy for Buffett to avoid was because he recognized how hard retail was. Buffett is an expert at using pattern recognition to his advantage, and he saw a lot of similarities between the difficulties Sears would end up facing and the troubles he had at both the department store that he bought in 1966 and also with Berkshire Hathaway itself (the textile business).

But his comments in 2005 about the Sears/Kmart merger and its potential pitfalls were not necessarily the popular viewpoint at the time. I think it's a great lesson to watch how easily he passed on the situation and how much common sense he exhibited with his simple explanation.

He didn't know for sure that it would fail, just like he didn't know for sure Freddie Mac would fail. But he did know for sure that it was too complicated, had too many variables, and the hurdles to clear were very high, and that was the overriding factor in his decision to pass on Sears (and to reverse course and sell with Freddie Mac).

I think the circle of competence gets probably far too much lip service and not enough actual implementation in the investment world, and I think one of Buffett's most underrated abilities is his willingness to both admit when he's wrong, change his mind, and generally just avoid altogether complicated situations.

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