Warren Buffet's Investing Wisdom, Part 2

Today Warren Buffet issued his latest annual report and letter to shareholders. Continuing from Part 1, here are some more of my favourite nuggets of Warren Buffet's wisdom from his previous annual letters to shareholders.

• John Stumpf, CEO of Wells Fargo, aptly dissected the recent behavior of many lenders: “It is interesting that the industry has invented new ways to lose money when the old ways seemed to work just fine.” (2007)
• I’ve reluctantly discarded the notion of my continuing to manage the portfolio after my death – abandoning my hope to give new meaning to the term “thinking outside the box.” (2007)
• For me, Ronald Reagan had it right: “It’s probably true that hard work never killed anyone – but why take the chance?” (2006)
• Warning: It’s time to eat your broccoli – I am now going to talk about accounting matters. I owe this to those Berkshire shareholders who love reading about debits and credits. I hope both of you find this discussion helpful. All others can skip this section; there will be no quiz. (2006)
• As a wise friend told me long ago, “If you want to get a reputation as a good businessman, be sure to get into a good business.” (2006)
• Long ago, Mark Twain said: “A man who tries to carry a cat home by its tail will learn a lesson that can be learned in no other way.” If Twain were around now, he might try winding up a derivatives business. After a few days, he would opt for cats. (2005)
• When we finally wind up Gen Re Securities, my feelings about its departure will be akin to those expressed in a country song, “My wife ran away with my best friend, and I sure miss him a lot.” (2005)
• Comp committees should adopt the attitude of Hank Greenberg, the Detroit slugger and a boyhood hero of mine. Hank’s son, Steve, at one time was a player’s agent. Representing an outfielder in negotiations with a major league club, Steve sounded out his dad about the size of the signing bonus he should ask for. Hank, a true pay-for-performance guy, got straight to the point, “What did he hit last year?” 
• When Steve answered “.246,” Hank’s comeback was immediate: “Ask for a uniform.” (2005)
• Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases. (2005)
• R. C. Willey will soon open in Reno. Before making this commitment, Bill and Scott again asked for my advice. Initially, I was pretty puffed up about the fact that they were consulting me. But then it dawned on me that the opinion of someone who is always wrong has its own special utility to decision-makers. (2004)
• John Maynard Keynes said in his masterful The General Theory: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” (Or, to put it in less elegant terms, lemmings as a class may be derided but never does an individual lemming get criticized.) (2004)
• Charlie and I detest taking even small risks unless we feel we are being adequately compensated for doing so. About as far as we will go down that path is to occasionally eat cottage cheese a day after the expiration date on the carton. (2003)
• [Regarding the annual meeting:] Charlie and I will answer questions until 3:30. We will tell you everything we know . . . and, at least in my case, more. (2003)
• Borsheim’s [Jewellery Store] operates on a gross margin that is fully twenty percentage points below that of its major rivals, so the more you buy, the more you save – at least that’s what my wife and daughter tell me. (Both were impressed early in life by the story of the boy who, after missing a street car, walked home and proudly announced that he had saved 5¢ by doing so. His father was irate: “Why didn’t you miss a cab and save 85¢?”) (2003)
• When I review the reserving errors that have been uncovered at General Re, a line from a country song seems apt: “I wish I didn’t know now what I didn’t know then.” (2002)
• We cherish cost-consciousness at Berkshire. Our model is the widow who went to the local newspaper to place an obituary notice. Told there was a 25-cents-a-word charge, she requested “Fred Brown died.” She was then informed there was a seven-word minimum. “Okay” the bereaved woman replied, “make it ‘Fred Brown died, golf clubs for sale’.” (2002)
• Bad terminology is the enemy of good thinking. When companies or investment professionals use terms such as "EBITDA" and "pro forma," they want you to unthinkingly accept concepts that are dangerously flawed. (In golf, my score is frequently below par on a pro forma basis: I have firm plans to "restructure" my putting stroke and therefore only count the swings I take before reaching the green.) (2001)

Warren Buffet's Investing Wisdom, Part 1

Around this time of year, Warren Buffet releases his shareholder letter in the annual report for his company Berkshire Hathaway.  For those not acquainted with Buffet, his writing style is much closer to the Farmer's Almanac than the Wall Street Journal.  It is far from the typical public relations hype that most corporations pile into their annual reports.

I remember the first time I discovered a Warren Buffet annual report.  I was rather surprised at the folksy anecdotes mixed in with razor-sharp astute financial insights.  More surprising to me was his brutal honesty about his failures and his modesty about his successes.  Humble billionaires are hard to come by.

His ability to understand and explain financial concepts is remarkable.  The best place to understand how insurance companies work is by reading his shareholder letters.  Because he built his empire on generating and investing "float" from his insurance ventures, he takes pains to have his shareholders understand what that concept means.

In his 2011 letter, his humility and insight is present as usual.  He admits his error on predicting a housing recovery in the U.S.

Last year, I told you that “a housing recovery will probably begin within a year or so.” I was dead wrong.

He then goes on to explain the two reasons why the housing market is guaranteed to recover:  hormones and in-laws.

Every day we are creating more households than housing units. People may postpone hitching up during uncertain times, but eventually hormones take over. And while “doubling-up” may be the initial reaction of some during a recession, living with
in-laws can quickly lose its allure.

Every other financial expert I have read makes economics sound complicated.  Warren makes economics sound profoundly simple.

Here is a collection of some of my favourite nuggets of Warren Buffet's wisdom from his annual letters to shareholders.

• I have made more than my share of mistakes buying small companies. Charlie long ago told me, “If something’s not worth doing at all, it’s not worth doing well,” and I should have listened harder. (2011) 
• Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.” (2011) 
• Cultures self-propagate. Winston Churchill once said, “You shape your houses and then they shape you.” That wisdom applies to businesses as well. Bureaucratic procedures beget more bureaucracy, and imperial corporate palaces induce imperious behavior. (As one wag put it, “You know you’re no longer CEO when you get in the back seat of your car and it doesn’t move.”) (2010) 
• Home ownership makes sense for most Americans, particularly at today’s lower prices and bargain interest rates. All things considered, the third best investment I ever made was the purchase of my home, though I would have made far more money had I instead rented and used the purchase money to buy stocks. (The two best investments were wedding rings.) For the $31,500 I paid for our house, my family and I gained 52 years of terrific memories with more to come. (2010) 
• As one investor said in 2009: “This is worse than divorce. I’ve lost half my net worth – and I still have my wife.” (2010) 
• Part of the appeal of Black-Scholes to auditors and regulators is that it produces a precise number. Charlie and I can’t supply one of those. Our inability to pinpoint a number doesn’t bother us: We would rather be approximately right than precisely wrong. (2010) 
• Unquestionably, some people have become very rich through the use of borrowed money. However, that’s also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade – and some relearned in 2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. (2010) 
• Long ago, Charlie laid out his strongest ambition: “All I want to know is where I’m going to die, so I’ll never go there.” (2009) 
• Long ago, Ben Graham taught me that “Price is what you pay; value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down. (2008) 
• As we view GEICO’s current opportunities, Tony and I feel like two hungry mosquitoes in a nudist camp. Juicy targets are everywhere. (2008) 
• Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas. (2008) 

More to come in Part 2.

Risk Management: Connecting Consequences with Decisions

I came across two articles recently whose themes on risk management intersected nicely.

The first article called “Avoiding Another Great Recession” is by a professor at London Business School named Julian Birkinshaw. He correctly attributes the market crash of 2007 to a huge failure in decision-making at some of the largest US banks, and that this particular problem has not yet been addressed. The risk of it repeating therefore remains high. His solution is to personalize the risk evaluation process in large companies. In his words, personalization “involves pushing the responsibility for evaluating and making a judgment around risk to those individuals who are making decisions – and requiring them to live with the consequences of those decisions.” He cites Goldman Sachs and JP Morgan Chase as examples of banks who have this personalization culture in place, and how they fared much better through the crash than other banks.

The second article in the Financial Post had the catchy title, “Why Swiss Banks Don’t Go Broke.” Richard W. Rahn explains how Swiss banks, particularly privately-owned Swiss banks, rode through the financial crisis so much better than banks in other countries. “Banks that are organized as general partnerships have had fewer problems because the partners have a very strong vested interest not to take on risks they do not fully understand because it is they who take the hit if something goes wrong.” Rahn goes on to propose an impractical solution called “mutual fund banking” but the rest of his article stands on its merits.

Bottom line: If you personally stand to lose everything from a careless investment decision, you tend to make fewer careless investment decisions!

As simple as this concept appears, it apparently has not been considered by governments when it comes to fixing the banking system. Governments prefer to believe that increasing and formalizing bureaucracy around these risk management processes will somehow reduce risk. The track records prove otherwise. Managing risk by increasing bureaucracy rarely seems to work. The Basel Accords are a good example.

Global central bankers set up the first Basel accord in 1988 to measure credit risks and to ensure banks retained sufficient reserves to cover those risks. Apparently this higher reserve requirement prompted JP Morgan to use credit default swaps to practically get around that requirement, and later those types of swaps played a significant role in the Lehman Brothers collapse in 2008. Warren Buffet predicted this danger in 2003, calling these swaps and other derivatives like them “financial weapons of mass destruction.”

Basel II was released in 2004 in an attempt to not only tackle credit risk, but other types of risk such as operational market, pension, and liquidity risk. It also failed to prevent the meltdown of 2007.

So, the solution to these regulatory failures? Basel III, currently in development. Just close your eyes, click your heels together three times, and it will be sure to succeed where its predecessors failed!

The failure of the Basel Accords is not in its content or a lack of expertise that went into it, but in its fundamental assumptions. Like Rahn points out, forcing banks to increase their reserves does not reduce the risk of their investments. To be safe, reserves must exceed the level of investment risk, which varies between banks and over time. There is no arbitrary reserve percentage that is safe enough. Safety comes in avoiding poor investments.

As a self-employed business owner, managing risk involves one person so it's not complicated. However, we're not immune from bad financial decisions either. I recently heard about a self-employed contractor who traveled a lot, but did not stay in the expensive hotels that his fellow self-employed contractors did. His comment: "They're spending money like it's not their own company."

And that's what it all boils down to: People have to make decisions like it's their own company, and then they have to experience both the rewards and consequences of those decisions like it's their own company.