Weekend Reading Vol. 22 — Christmas in February
Growing up, there were few things greater than Christmas morning. What had Santa brought? Would there be a Tamagotchi in my stocking? Starting around 4:45am, I would not so subtly get up every fifteen to twenty minutes to look under the tree, much to my parent’s chagrin.
5am. Go back to bed my parents would say. 5:15am. Go back to bed. 5:40am. Go back to bed. You get the idea.
But time moves on and people change. Christmas is now an opportunity to sleep in. Today the closest thing I have to that childhood Christmas morning excitement is when Berkshire Hathaway releases its annual letter to shareholders in late February.
Every year Warren Buffett packs his annual letter full of wit and wisdom and this year was no exception. Here are a few of the key lessons:
Don’t Ask the Barber if You Need a Haircut
Be mindful of conflicts and incentives. This is particularly true regarding financial transactions. Banks are intermediaries and intermediaries make money from transactions. When you trade they take a cut. When you acquire a company they take a cut. When you go public they take a cut. Not surprisingly:
“Fees too often lead to transactions rather than transactions leading to fees…Sitting tight is seldom recommended by Wall Street. (Don’t ask the barber whether you need a haircut.)”
When somebody is trying to win your business, they may call you pretty and say that you’re a tech company, but really you just sell mattresses-in-a-box. Take flattery with a grain of salt when you’re the one writing checks. In addition, practice increased skepticism around projections, particularly if the term synergy is involved. Most of the time, two plus two simply equals four:
“In striving to achieve the desired per-share number, a panting CEO and his “helpers” will often conjure up fanciful “synergies.” (As a director of 19 companies over the years, I’ve never heard “dis-synergies” mentioned, though I’ve witnessed plenty of these once deals have closed.) Post mortems of acquisitions, in which reality is honestly compared to the original projections, are rare in American boardrooms. They should instead be standard practice.”
Few things move up and to the right indefinitely, though you wouldn’t get that impression from looking at most Powerpoint presentations.
The Value of Dry Powder
Berkshire Hathaway sits on over $120B of cash and short-term investments. Some investors view this as excessive and Buffett himself has lamented the lack of large scale acquisitions available at fair prices. But conservatism and discipline are two of Berkshire’s guiding principles. One reason for this is that survival is a precondition for success:
“Financial staying power requires a company to maintain three strengths under all circumstances: (1) a large and reliable stream of earnings; (2) massive liquid assets and (3) no significant near-term cash requirements. Ignoring that last necessity is what usually leads companies to experience unexpected problems: Too often, CEOs of profitable companies feel they will always be able to refund maturing obligations, however large these are. In 2008–2009, many managements learned how perilous that mindset can be.”
Events like recessions, natural disasters, and wars are inevitable (see: all of human history). The COVID-19 pandemic is likely to make the above point a harsh reality for some businesses. Running lean on inventory or leveraging up the balance sheet may juice financial returns for a time. But they can also be picking up pennies in front of a steamroller. Business models that work well under normal circumstances can break down under stress. Make sure you’re operating with some buffer in place. As Buffett would say:
“It’s only when the tide goes out that you learn who has been swimming naked.”
This cash pile also enables Berkshire to act opportunistically:
“The reason for our conservatism, which may impress some people as extreme, is that it is entirely predictable that people will occasionally panic, but not at all predictable when this will happen. Though practically all days are relatively uneventful, tomorrow is always uncertain. (I felt no special apprehension on December 6, 1941 or September 10, 2001.) And if you can’t predict what tomorrow will bring, you must be prepared for whatever it does…In our view, it is madness to risk losing what you need in pursuing what you simply desire.”
When you’re the only one with an open checkbook and others need liquidity, you can dictate the terms. This piece of the Berkshire playbook shows up repeatedly over the years. When Lehman Brothers was in trouble, Buffett got the call (he declined). Same with Bank of America, Goldman Sachs, and Long Term Capital Management.
Know Your Limitations & Bet Aggressively When You Have An Advantage
Lastly, understand the limitations of your knowledge and expertise. To maximize your chances of success, stay within your circle of competence:
“We are limited, of course, to businesses whose economic prospects we can evaluate. And that’s a serious limitation: Charlie and I have no idea what a great many companies will look like ten years from now.”
Ted Williams, one of the best hitters in Major League Baseball history, provides a good example. Williams knew that when a pitch was in a certain area, he had a high likelihood of getting a hit. So William’s strategy was to wait for a good pitch and not to swing at pitches out of his sweet spot.
One of the reasons Buffett and his business partner Charlie Munger avoided technology stocks for so long was that they didn’t understand the businesses. This means they missed out on investing on Amazon and Google at an early stage, but it also means that they missed out on the worst of the dotcom bust carnage. Don’t invest in things you don’t understand (see: cryptocurrency).
The flipside of this is that when Buffett understands a business and sees good value, he acts aggressively and decisively:
“Thanks to a 1951 conversation I had with Lorimer Davidson, a wonderful man who later became CEO of the company, I learned that GEICO was a terrific business and promptly put 65% of my $9,800 net worth into its shares.”
This is contrary to the don’t put all your eggs in one basket advice you often hear. But good ideas are rare. When you have one, pursue it.
Have a good weekend.
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