Berkshire Ruminations

Monday, June 26, 2006

Warren Buffett to give his money away... now!

A lot of people have been asking me “What do you think of Buffett’s decision to give away his money?” I can only answer that if he has made that decision, it must be the wisest thing to do. In case you haven’t heard, Mr. Buffett announced over the weekend that he would begin giving away nearly all of his fortune this year with the majority going to the Bill and Melinda Gates Foundation. This was a surprise, since for a long time Mr. Buffett held that he would not make any major donations until his death, and that when that happened his estate would go to his foundation, now called the Susan T. Buffett Foundation in honor of his late wife. This attitude offended some, particularly those ignorant of his rationale, as it seemed he was selfishly holding on to more than he needed.

To me, though, his rationale always made sense. The longer he waited to give to charity, the more he could give when the time came. Mr. Buffett is truly a money machine, so he could give, say, $40 billion today at age 75 or he could wait and give more than $160 billion upon death - assuming he dies at age 85 and a conservative (for Berkshire) growth rate of 15% per annum. That is, $40 billion * (1.15)^10 = $161 billion

Why would he do this? Presumably because he felt there were issues so pressing that it was more important to address them now than to address them later with more money. This issue arose several years ago when he became involved with the Nuclear Threat Initiative (NTI), which tackles “the single largest threat to mankind” as Buffett himself described it, nuclear weapons in the hands of terrorists. In an interview with Ted Koppel last year, Buffett explained his departure from his general policy to withhold charitable giving until his death by saying that there simply wasn’t time to waste, that this issue needed to be addressed immediately.

And so I would expect that this was the primary reason why he decided to give early, although it is speculated that the untimely death of his wife in 2004 was a contributing factor as well. Susan Buffett was the champion of the Buffett Foundation, and Warren always expected her to carry out its purpose upon his death. But now that she is gone, apparently, Mr. Buffett feels most comfortable leaving his fortune in the hands of the Gates Foundation. This is quite a compliment to his friend Bill Gates, who just recently left most of his responsibilities at Microsoft so he could focus on his foundation.

I think it is emblematic of Mr. Buffett’s truly outstanding character and humility that he would choose to disperse his wealth in such a philanthropic way. His children will get little of it, since they are already so fortunate themselves. Moreover, as he himself once said, “When society showers money upon you just because you have some peculiar talent, I think society has a large claim on that wealth.”

It is easy to assume that a man so wealthy is arrogant and selfish, but Warren Buffett is not. In fact, he is one of the most pleasant and genuine personalities I have been exposed to. When I first began to learn about the man, I expected that eventually I would uncover an objectionable and disappointing quality that would sour me on my admiration of him. But in all this time, I have found only good things. Mr. Buffett once said “Tell me who a person’s heroes are and I can tell you how that person will turn out.” I hope he is right, because Warren Buffett is my hero…

Friday, June 23, 2006

Value investing, in a (very small) nutshell.

People familiar with him will usually be able to identify a “Warren Buffett” stock when we see one, but at times I have been stumped as to explain why a certain company is consistent with his philosophy. Teaching the Warren Buffett Course at MU and being forced to design a framework for making investment decisions made things immensely clearer to me. For one, and contrary to popular belief, there is no set of rules that every company must follow in order to be a good Berkshire investment. Rather, there is an array of different structures and characteristics that when operating concurrently produce a profitable and value-producing business.

For example, we often think of a Buffett company as having tremendous brand equity – “franchise value” as Mr. Buffett calls it. Mr. Buffett prefers to avoid companies that sell commodity products on which a customer will base his purchase decision primarily on price. How then, do we reconcile this principle with his investments in insurance or energy, neither of which has an important brand identity? The answer to the insurance question is simply “float” and the answer to the energy question is the favorable regulatory outlook that Berkshire foresaw. The point is, however, that there are numerous variables, all of which may make for a good investment. Not every company needs to a have a strong brand, nor does every company need management that behaves a certain way, say for instance one that expenses stock options.

This is because all of the characteristics we think of as prerequisites for a Berkshire investment, are nothing more than an indication of value. In the end, every purchase comes down to this one word. After all, Mr. Buffett is the world’s greatest value investor. A strong brand adds value. Good management adds value. The existence of float adds value and a favorable regulatory outlook adds value. The way we measure this value, in my opinion, is a general assessment of all the qualities that a make a company good, adjusting for all the other qualities that make it bad. If, after careful thought and consideration, Mr. Buffett decides that on the whole the company has more value than its current price would suggest, he will consider buying. It is that simple.

Wednesday, June 14, 2006

What is up with this market?!?!

This market is really hard to take. Every day, lower prices. But one stock that has hung in there is Old Dependable, Berkshire Hathaway. I won’t begin to speculate why the market has been doing so poorly the last couple months, whether this is a correction or the start of a bear market, but the fact that BRK has outperformed is a testament to the trust its shareholders have in its operations and the strength of its portfolio.

To illustrate, ask yourself this question, Do you have any doubt that Berkshire is not a strong as its price would justify? For me that question is no, but for many of my other holdings, I can’t say that with as great of confidence. BRK pays no dividend, but has the lowest turnover ratio on the NYSE and attracts a faithful horde of 20,000+ individuals to its annual meeting. Clearly, these shareholders are something special.

As a value investor, I try to keep an eye on the “biggest losers” list, to try to catch stocks unfairly punished by the market, particularly when everything is going down. But this can be a risky strategy to follow without very careful diligence.

For instance, Jos. A. Banks (JOSB) shares got slaughtered when the company released some disappointing earnings last week, but it was likely the timing of the announcement – right in the middle of a market downturn when investors were already uneasy – that caused the 35% drop. Or take Monster (MNST) who is currently center stage in the stock options backdating scandal. Had this scandal broken in January, perhaps the shares wouldn’t have fallen nearly 40% as they have.

A more conservative and appealing strategy is to try to pick up some shares of great companies at a small discount. Coach Inc. (COH) comes to mind. This is a great, consistent, well-positioned company, which I have always had an eye on but has always seemed expensive. At $28/share, down from a recent high of $36, the company now stands at 23 times ttm earnings. Still pricey, but much cheaper than it was only a few weeks ago. And the fundamentals, if anything, have only improved.

To summarize, there still doesn’t seem to be a lot for the picking at the moment, but certainly we have a longer watch list. So buffer your portfolio with BRK, and watch for bargains…

Monday, June 12, 2006

What is behavioral finance?

Efficient market theory has been around since the 1960s and gained considerable steam during the long bear market in the 1970s. It was standard dogma in universities for several decades and was never directly challenged. Meanwhile various professors began publishing papers that documented real-world anomalies, phenomena that seemed to be impossible under the assumptions of EMT. That is, they found cracks in the efficient market foundation. As more and more anomalies were documented, more and more doubts grew about the validity of the theory and an alternative notion, behavioral finance, was born.

EMT was never that popular on Wall Street anyway, of course. If EMT held, a good portion of those whose livelihood was made there would be out of business, an unattractive notion for sure. It was much more appealing to them to go about their lives assuming that, at least, it was possible to beat the market, even if they weren’t beating the market themselves. Ironically, this sort of self-denial, whether it was true or not, is a great example of the type of bias that plays a role in behavioral finance.

Behavioral finance has been around now for about twenty years, but only widely accepted recently. As I see it, it is the natural evolution of academic finance generally. Indeed, Professor Richard Thaler – the most prominent name in behavioral finance – even authored a paper entitled “The End of Behavioral Finance,” (Financial Analysts Journal, Nov/Dec 1999 – a great summary which I highly recommend) suggesting that eventually the modifier “behavioral” won’t even be needed.

Traditional theory assumes that decision makers act rationally, that the make unbiased judgments and that they always act in a way to maximize their individual well-being. Most psychologists will tell you this is an unrealistic assumption to make about human behavior, and so a great deal of behavioral finance research has been done in conjunction with psychologists.

Two psychologists, Amos Tversky and Daniel Kahneman, set the stage in the late 70s with “Prospect Theory” which examines how individuals make decisions. Within this framework, they developed the notion of “loss aversion.” Individuals aren’t afraid of risk, they are just afraid of the risk of losing. When confronted with gains, people are more likely to seek risk than when confronted with equally probable losses. That is, investors aren’t risk-averse, they are loss-averse. Thaler later performed an experiment that demonstrates this tendency. Students were told to assume they had just won $30 and were offered a coin-flip upon which they would win or lose $9. Seventy percent of the students opted for the coin-flip. When other students were offered $30 for certain versus a coin-flip in which they got either $21 or $39 a much smaller proportion, 43%, opted for the coin-flip. EMT holds that individuals weigh these probabilities without bias, and under such assumptions results like this would not occur.

There are two key points to the idea of behavioral finance: 1) investor irrationality/psychology and 2) limits to arbitrage. EMT does not rule out the possibility that investors act irrationally, but only that if they do their actions will be exploited by rational investors and arbitraged away. For example, in the case of Palm/3Com, where Palm shares were dramatically overpriced, EMT proponents would have expected short sellers to continue to sell the shares until they fell in price, making a quick arbitrage profit. But because there were simply not enough shares available to be shorted, the price remained high, as ordinary selling pressure was not enough to offset the irrational optimism of buyers.

If we can assume that there are times when arbitrage opportunities are limited, and that there are times when investors give in to behavioral biases and make irrational decisions, then an entire new world of finance just waits to be explored. How and why do investors make irrational decisions? Are these behaviors predictable? These are the types of questions that are starting to get answered in financial literature today.