Notes – The Snowball, By Alice Schroeder: Part I, Chap. 1-4

The following are reading notes for The Snowball: Warren Buffett and the Business of Life, by Alice Schroeder. This post covers Part I: The Bubble, Chap. 1-4

Why Warren Buffett is driven to make money

The first chapter of The Snowball opens with the author interviewing Buffett in his office at Kiewit Plaza. She asks,

Where did it come from, Warren? Caring so much about making money?

Interestingly, Buffett’s response is something of a non-sequitur:

Balzac said that behind every great fortune lies a crime. That’s not true at Berkshire.

Are we supposed to believe this means Buffett is ultimately a moralizer? That he’s driven to make money just to show it can be done in an honest fashion? If so, where does THAT come from? You see, Buffett didn’t answer the question posed to him.

We also learn that Buffett reads voraciously, and that he watches CNBC (on mute, just to get the scroll of news stories and market developments). Every good investor knows CNBC is a bunch of noise, it is not edifying and it is distracting. It’s peculiar that a long-term oriented, value investor like Buffett would make CNBC part of his daily routine.

Buffett travels to Sun Valley, Idaho, July 1999

We begin to see Buffett as a completely self-absorbed individual. As he travels with a contingent of his family (children and grandchildren) to the Allen & Co. “elephant-bumping” retreat in Sun Valley, the man never looks out the window of his G4 and

He sat reading, hidden behind his newspapers, as if he were alone in his study at home

where, apparently, he treats his significant other, Astrid Meeks, in similar fashion, as noted in a later chapter which depicts Astrid as something of a live-in hamburger-making, Coke-delivering otherwise-invisible person who tries not to disturb the Great Warren during his nightly routine of hours of online bridge and conversations with his insurance lieutenant, Ajit Jain, at 10PM at night. Everyone’s entitled to their flaws and interpersonal relationships seem to be one of Buffett’s.

Which is interesting, because he goes to great pains in Sun Valley to be liked by everyone. Buffett

liked few things more than getting a free golf shirt from a friend [Allen & Co.’s president and organizer of the outing]

and he

went out of his way not to be disliked by anyone

Somewhat peculiar juxtaposed social relationships for a man who waxes philosophical about the Inner Scorecard versus Outer Scorecard in life, one being a measure of self as seen by self, the other being a measure of self as seen by others. You’d think neglecting your family while making pains to impress social acquaintances would register on the Inner Scorecard, but no matter.

This isn’t a Beat Up Buffett blog– the man has a lot to teach and I have a lot to learn. I just find these items odd as I read.

The festivities in Idaho are noteworthy because of what an extremely above-average experience it is for the people involved when compared to daily existence for the Average American, let alone the Average Human Being. To wit, after “white water river rafting” down a stream lined with ambulances and quick response teams for safety (and, one might imagine, helicopter gunships for security),

the guests were handed warm towels as soon as they put down their paddles and stepped out of the rafts, then served plates of barbecue

In addition,

Reporters were banned [from covering the outing]… [the various money managers in attendance represented] more than a trillion dollars [in combined wealth under management]

This is unusual company, an elite group within society, wittingly or not. There is nothing wrong with this level of affluence, it’s simply worth mentioning to set Buffett’s life into context– he’s not of us, at least not at this point in his career.

The key scene at Sun Valley is Buffett’s economic-prediction-as-financial-market-lesson-speech in which he lectures the newly minted tech bubble millionaire crowd on economic cycles and sound investing. A few notes:

  • Most people treat stocks like chips in a casino; Buffett sees the chips represent ownership in businesses (entities that create more chips over time)
  • Technology is not a guaranteed win for investors; history is replete with new technologies that made huge improvements in everyone’s standard of living, yet few had made investors rich (ie, the automobile, and the 3,000 original manufacturers that had over time combined into 3 major firms in the US; airline industry, $0 made in the aggregate stock investments in the industry’s lifetime)
  • Valuing is not the same as predicting
  • What you’re doing when you invest is deferring consumption and laying money out now to get more money back at a later time. And there are really only two questions. One is how much you’re going to get back, and the other is when.
  • As interest rates vary, the value of all financial assets change
  • Three ways the stock market can grow faster than the economy:
    • interest rates fall and remain below historic levels
    • share of the economy going to investors as opposed to employees, government, etc., remains above historic levels
    • the economy grows faster than normal
  • Book value: the amount of money that had been put into the business and left there
  • Ultimately, the value of the stock market can only reflect the output of the economy; on average, the return of the stock market is about 6% a year

Buffett also makes reference to “Lord Keynes”; not that it’s a big secret, but I don’t know anyone who isn’t a Keynesian who refers to Keynes that way (with prestige and respect for the State-granted honorific). If it wasn’t obvious otherwise, I’d say this is evidence enough of Buffett being a Keynesian.

Buffett also lives by the rule, “Praise by name, criticize by category.” That’s very Dale Carnegie-esque.

Enter the Munger

In Part I, we’re also introduced to Buffett’s curmudgeonly friend and business partner, Charlie Munger.

Munger is a graduate of Harvard Law School. He also

admired [Benjamin] Franklin for espousing Protestant bourgeois values while living as he damn well pleased

We also learn a curious fact about Munger’s charitable practice, which

took the form of a Darwinian quest to boost the brightest

but often took the form of “noblesse oblige” because he attached many strings to his giving which were “for the recipients own good, because he knew best” (Schroeder’s articulation). Munger and Buffett are famous for their hands-off, passive management approach to their acquired businesses; yet when it comes to charity, Munger is a world-saver who tries to micro-manage things to an almost tyrannical degree. It seems like a mismatch, but, when combined with his love of Franklin’s philosophical pragmatism and his background at Harvard, it fits the egotistical elitist mold quite well.

Munger, like Buffett, reads a great deal, tearing through newspapers and periodicals everywhere he goes. And Munger, like Buffett, seems quite impressed with his father– Munger carries his father’s old briefcase and vacations at his father’s old Minnesota cabin, while Buffett has a shrine-like portrait of his father in his office and claims he’s “never seen anybody quite like him.”

Revisiting the theme of “Why does Buffett watch CNBC?”, Buffett is subscribed to several newsletters about stocks and bonds and he reads the daily, weekly and monthly operating reports of the Berkshire subsidiary companies. For someone with a long-term orientation, it seems puzzling he would be fascinated or concerned with this kind of contemporaneous minutiae, but perhaps his is simply a mind that thrives on volumes of data to create patterns, impressions and meaning.

Finally, when we learn about Buffett’s two scorecards, we also learn that Buffett pays “close attention” to the rankings of the world’s wealthiest people. This standing would appear to reside on the Outer Scorecard which Buffett warns against measuring one’s life against.

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Notes – Horizon Kinetics 2014 Compendium, Skepticism About Indexation

For the last two years, Murray Stahl and Steve Bregman of Horizon Kinetics have published a “Compendium Compilation” of their various research pieces and market commentaries throughout the year. I recently requested copies of the 2014 and 2015 compendiums and just completed reading through the 2014 compendium.

The Scourge of Indexation

The single biggest trend that Stahl and Bregman have been criticizing for years is the rise and dominance of indexation as passively-managed ETFs as the practical consequence of widespread adoption of the Efficient Market Hypothesis. I collected comments from several different essays and stitched them together into a meta-commentary on the phenomenon:

We are reliably informed by many academicians that growth, value, momentum, yield and volatility are fundamental attributes for portfolios and, as such, are the determinants of performance. Numerous studies assert this as true. However, the studies were all done on the opportunity set of stocks, not actually on funds organized upon the findings of the research. In other words, these studies predate the implementation of the conclusions of the studies.

The efficient markets hypothesis is subject to no serious scholarly challenge. Indexation is by far the largest investment strategy and it is growing in acceptance by the day.

One could argue convincingly that markets are efficient if the market place is made up of a multiplicity of active managers gathering information and, by their trading, expressing that information in the prices of securities. However, as we saw in the Facts and Figures section, if the majority of the dominant investors, who are also the marginal buyers and sellers, are now passive, and if this dominance is growing, how can one be sure that the efficient market model remains a valid assumption?

What does it mean when one — that is, the investment ecosphere — creates multi-trillion-dollar managers that are valuation indifferent?

You cannot merely have trillions of dollars invested in indexes and assume that everything will be the same as it was before they were investing in indexes.

For 40 years, indexation worked because of four trends. There was a strong fiscal stimulus to promote the demand in most countries. Companies engaged in cost-cutting and eliminated marginal products and divisions, thereby increasing margins. Corporate tax rates have been declining for 40 years, and interest rates have been declining for decades. Companies, however, cannot count on those four benefits anymore.

We are going to replace poor judgment with no judgment whatsoever.

…an unintended consequence of the indexation movement is the creation of quasi-permanent holding companies for [S&P 500 and other major index stocks]

To my mind, the rise of indexation represents something of a corporate governance crisis in this country and any other where passive index funds account for a substantial proportion of the total shares outstanding in the market place (for purposes of this argument, I’ll peg that number at 20% which just so happens to be how much are currently owned by passive funds according to a recent New Yorker piece). Looked at in very simple terms, that is 20% of the shares of the average public company that have no active agency behind them, that is, there is nobody scrutinizing the operations of the company and the efficacy and honesty of its management by or on behalf of the shareholder whose capital is at risk. Given how many individual and even institutional shareholders are already “actively disengaged” from their duty to provide capitalist oversight of the companies they own, this is a troubling context to invest in if you believe that sound corporate governance is a key ingredient for above average investment returns and safety of capital at risk.

It reminds me strongly of one of the quotes from my recent review of Panic, “Underpinning the ideology of modern finance is the notion that the insight, judgment and even diligence of the entrepreneur are irrelevant for investing in public securities markets. These markets, we are told, are special, too powerful and too perfect to allow any entrepreneur’s judgment to matter.”

This indexation phenomenon has gone beyond influencing the markets to the point that it is “making” them, an inevitable consequence of gamification:

BlackRock… has issued a call for reform… [their] paper calls for the standardization of features of newly issued bonds. For example, an issuer would not be free to issue bonds with any features it wanted; it would have to issue them in certain standard packages, which are defined in the paper. BlackRock’s proposed change is an example of how indexation as a business is beginning to reflect the market as it impinges upon the index providers’ business needs.

Bonds have different characteristics because they represent different kinds of risks with different kinds of borrowers and lenders. While it’s possible to standardize anything for most applications, this is decidedly a “new era” where the standardization process is not being driven by the desire to reduce costs and confusion for borrowers and lenders per se, but rather it is being driven by the desire to efficiently index such media whose performance can then be captured in an ETF. It’s an important difference considering the fact that risk can not be standardized away just so that an investor can more easily allocate his funds.

In time, these indexes just end up playing themselves, as Stahl warns:

It is important to keep track of how the indexes are going to be tilted because that has two sets of implications. First, it has implications for the businesses of the index orchestrators, but second, it has implications for the entire marketplace. Whichever way a given sector gets tilted, either positively or negatively, the amount of money involved is so huge that it is going to be either the best-performing sector or the worst-performing sector.

Some Other Strange Side Effects Of Indexation

I captured a few other anecdotes related to indexation and EMH that I thought were memorable. One concerned the changes occurring in the utility industry. Stahl shared numerous statistics demonstrating the rapid rate of increase in solar power production, explained the different economics of solar (especially once installed) compared to gas, coal or nuclear powered generation and then surveyed the effect that the reach for yield and the indexation of the utility industry have created “priced to perfection” conditions in the publicly traded utilities firms. He concluded:

The asset allocation to yield-oriented stocks relies upon historical data regarding stability of dividends, which date back decades. The allocators treat this data as if they are immutable, scientific constants… They are completely unaware that a dividend quality constant is about to manifest a certain degree of inconstancy… This is an important phenomenon happening in the world of utilities, and people should remain very cognizant of it.

He also commented on the role volatility plays in the EMH:

In theory [institutions] are all fleeing volatility, but in reality are they merely fleeing volatility or, said another way, is volatility merely wherever they are going to be?

Connected to that idea is the degree of correlation which many investments are experiencing:

One can sell all of one’s investments and replace them with gaming stocks, and still have a correlation of 0.9726 with the S&P 500. It is an incredible statistic when you think about it.

Why should a presumably rational investor buy the more volatile Russell 2000 Index for a long period of time only to see it fail to outperform, or even underperform, the less volatile S&P 500 index?

And he brought further scrutiny on the idea of boiling down the predictive performance of a stock to one or two variables, such as volatility:

Companies possess many characteristics so it is difficult to assign causative factors to any one of them without knowing the other characteristics in that factor universe.

Miscellaneous Ideas

I also enjoyed Stahl’s commentary on including land in one’s diversified portfolio (again, these comments are stitched together from various essays):

Land held its value during the Great Depression.

Comparing and contrasting land with gold, it is clear that there were many periods when gold did not appreciate.

Government regulations sometimes affect the value of gold, but it is hard to envision government regulations that would affect the vast panoply of land resources in the world in some uniform way. Therefore, land is worth considering as a portfolio asset.

Land is not a hedge against political instability, which gold is because gold is mobile. Land is not mobile so it is only a hedge against inflation, not against political instability. Sometimes political instability and inflation come together.

He shared a contrarian view on eliminating an equity from consideration simply because it carries a high earnings multiple:

We cannot merely assert that if a company trades at 57x earnings, we will dismiss it as an investment. That would be an escape from reality… a Google at 15x earnings would be preposterously valued.

As long as it is possible to create companies at this scale of revenue, then not a few companies will trade at high P/Es. it looks like it is going to be a permanent part of the investment landscape.

Google’s valuation at the time it went public was around 57x earnings, and it’s market cap exploded from there. An interesting question is why it wasn’t valued even more highly given its realized potential?

Stahl observed a dichotomy between bond market interest rates and duration:

The interest rate is more or less engineered by the Federal Reserve, but the weighted average life reflects the risk preferences of bond investors.

Finally, I really liked this “bubble” related quote he shared from G.K. Chesterton:

There are no rules of architecture for a castle in the clouds.