This is the second part of the seventeenth in a series of blog posts that will analyze / summarize Warren Buffett's shareholder letters from 1977-2015. For all of the prior shareholder letters, see here.
A FEW GENERAL THOUGHTS ON INVESTMENT STRATEGY
1. AGAIN--IT'S BUY AND HOLD GREAT BUSINESSES, STUPID
Buffett returns to a theme echoed in prior letters, that an investor should view his or her holdings the same way a corporate CEO would view his subsidiaries (i.e., as businesses, not stock symbols):
[W]e continue to think that it is usually foolish to part with an interest in a business that is both understandable and durably wonderful. Business interests of that kind are simply too hard to replace. Interestingly, corporate managers have no trouble understanding that point when they are focusing on a business they operate: A parent company that owns a subsidiary with superb long- term economics is not likely to sell that entity regardless of price. "Why," the CEO would ask, "should I part with my crown jewel?" Yet that same CEO, when it comes to running his personal investment portfolio, will offhandedly - and even impetuously - move from business to business when presented with no more than superficial arguments by his broker for doing so. The worst of these is perhaps, "You can't go broke taking a profit." Can you imagine a CEO using this line to urge his board to sell a star subsidiary? In our view, what makes sense in business also makes sense in stocks: An investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business...
Charlie and I decided long ago that in an investment lifetime it's just too hard to make hundreds of smart decisions. That judgment became ever more compelling as Berkshire's capital mushroomed and the universe of investments that could significantly affect our results shrank dramatically. Therefore, we adopted a strategy that required our being smart - and not too smart at that - only a very few times. Indeed, we'll now settle for one good idea a year. (Charlie says it's my turn.)
2. DIVERSIFICATION USUALLY = DIWORSIFICATION
Buffett goes on to state his view that, for an active or "enterprising" investor, diversification usually results in lower, not higher, returns. This is because there are only so many great stock ideas out there and, just as an investor tends to "reach for yield" in bull markets, so an investor might "reach for diworsification" with respect to his or her portfolio:
The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as "the possibility of loss or injury."
In other words, to outperform it is best to stick with one's best ideas and discard all of the rest:
[I[f you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices - the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: "Too much of a good thing can be wonderful."
3. A DEFINITION OF RISK AND WHY VOLATILITY IS GOOD
When Dr. Johnson was asked by a woman why he got the definition of "Pastern" wrong in his famous dictionary, he replied "Ignorance, Madam, pure ignorance." Risk, maintains Buffett, has nothing to do with volatility, "beta" or other fancy market jargon. Rather, risk is not knowing what you are doing--it is simple ignorance. The way to avoid investment risk is to know all of the relevant facts regarding an investment and apply logical reasoning thereto. Buffett states as follows:
Academics, however, like to define investment "risk" differently, averring that it is the relative volatility of a stock or portfolio of stocks - that is, their volatility as compared to that of a large universe of stocks. Employing data bases and statistical skills, these academics compute with precision the "beta" of a stock - its relative volatility in the past - and then build arcane investment and capital-allocation theories around this calculation. In their hunger for a single statistic to measure risk, however, they forget a fundamental principle: It is better to be approximately right than precisely wrong. For owners of a business - and that's the way we think of shareholders - the academics' definition of risk is far off the mark, so much so that it produces absurdities. For example, under beta-based theory, a stock that has dropped very sharply compared to the market - as had Washington Post when we bought it in 1973 - becomes "riskier" at the lower price than it was at the higher price. Would that description have then made any sense to someone who was offered the entire company at a vastly-reduced price?
Similarly, Buffett rejects the conventional notion that stock volatility is a bad thing:
In fact, the true investor welcomes volatility. Ben Graham explained why in Chapter 8 of The Intelligent Investor. There he introduced "Mr. Market," an obliging fellow who shows up every day to either buy from you or sell to you, whichever you wish. The more manic-depressive this chap is, the greater the opportunities available to the investor. That's true because a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses. It is impossible to see how the availability of such prices can be thought of as increasing the hazards for an investor who is totally free to either ignore the market or exploit its folly. In assessing risk, a beta purist will disdain examining what a company produces, what its competitors are doing, or how much borrowed money the business employs. He may even prefer not to know the company's name. What he treasures is the price history of its stock. In contrast, we'll happily forgo knowing the price history and instead will seek whatever information will further our understanding of the company's business. After we buy a stock, consequently, we would not be disturbed if markets closed for a year or two. We don't need a daily quote on our 100% position in See's or H. H. Brown to validate our well-being. Why, then, should we need a quote on our 7% interest in Coke?
Buffett divides boards of directors into three separate categories: (1) where there is no controlling shareholder; (2) where the controlling owner is also the manager; and (3) where there is a controlling owner who is not involved in management.
In the first case, it is up to the directors to make sure that management is doing its job properly, meaning both in terms of skill but also in terms of loyalty to the absentee owners (the shareholders). Buffett says that if management strays too far from the mark, it is the duty of the board members to slap their hands. However, he believes that it is also acceptable for individual board members to speak out publicly when they see something they dislike, even if the other board members disagree. This is virtually never seen with public companies today--directors are much more likely to either do nothing or quietly resign for "family" or "health" reasons. The problem with this is that it leaves the owners of the business, the shareholders, completely in the dark regarding issues they should know about. Buffett concludes that, in this scenario, "directors often find it very difficult to deal with mediocrity or mild over-reaching" by management (and, hence, such mediocrity and/or over-reaching can persist for extended periods of time), noting also that "directors trapped in situations of this kind usually convince themselves that by staying around they can do at least some good".
In the second case, the outside directors will likely have no ability to influence the fate of the applicable company, since the controlling owner is highly unlikely to fire himself or herself. Anyone doubting this should look at (in a different context) the tenure of Jerry Jones as the general manager of the Cowboys--win or lose, Jerry Jones the GM has pretty darn good job security.
Buffett contends that the third case represents "the most effective [scenario for] insuring first-class management", since in this case the outside director needs only to go straight to the controlling shareholder (bypassing the other directors) to report any issue with management, and the controlling shareholder can take decisive action to remedy whatever problem might exist:
In the third case, the owner is neither judging himself nor burdened with the problem of garnering a majority. He can also insure that outside directors are selected who will bring useful qualities to the board. These directors, in turn, will know that the good advice they give will reach the right ears, rather than being stifled by a recalcitrant management. If the controlling owner is intelligent and self-confident, he will make decisions in respect to management that are meritocratic and pro-shareholder. Moreover - and this is critically important - he can readily correct any mistake he makes.
Therefore, when assessing potential investments, perhaps investors should only focus on those that fit category three rather than the other two. So much for that SNAP long position one may have been contemplating...
For the record, in 1993 Berkshire's stock was up 39%, beating the market by 29%, the Blue Jays beat the Phillies in the World Series in six games, the Cowboys once again demolished the Bills 30-13 in Super Bowl XXVIII and on October 13th our 45th President's daughter Tiffany entered the world (yes, she has her own Wiki page). Next up, 1994, the year we said goodbye to the front man from Nirvana and hello to the Biebs in the space of just about a month (any chance we can reverse that trade?)