Below are several quotes, and in this letter we will give our brief thoughts on how each one should be applied to meet the challenges of making money without undue risk in today’s markets.
“I skate to where the puck is going, not to where it has been.” – Wayne Gretzky
“I can calculate the movement of stars, but not the madness of men.” – Sir Isaac Newton
“American business will do fine over time. And stocks will do well just as certainly, since their fate is tied to business performance. Periodic setbacks will occur, yes, but investors and managers are in a game that is heavily stacked in their favor.” – Warren Buffett
“Nurture your flowers and cut your weeds.” -- Proverb
“You don’t need to know a man’s weight to know that he’s fat;” and “Investment is most intelligent when it is most businesslike.” – Benjamin Graham
“Go for a business that any idiot can run – because sooner or later any idiot is going to run it;” and “Never invest in any idea you can’t illustrate with a crayon.” – Peter Lynch
“I never buy at the bottom, and I always sell too soon.” – the original Baron Rothschild on his secret for making money on the Bourse
“The best performance is produced by a person, not a committee;” and “It is impossible to produce a superior performance unless you do something different from the majority.” – John Templeton
“The last asset I would
want to buy is a 30-year government bond,” and, when
asked if he’d purchase a 10-year bond replied that
“I don’t want a 10-day bond. There is a good chance,
who knows what the probability is, but that a
30-year bond, you know, with a 2.5% coupon, I mean
that bond could sell at 60 very easily, you know,
sometime in the not too distant future.” – Warren
Buffett in February 2015
Wayne Gretzgy quote on going to where the puck will be
What makes investing hard is predicting the future. After all, if you could simply look to the past, the best money managers would be librarians! You need to decide what is going the way of A&P, and what has a terrific future (we hope) like Costco. And you may decide a company has a great future, but get parts of that future wrong – as we did in thinking that Costco would be selling far more cars today than it does. Essentially, you must forecast what a business will sell in the future and what the cash flows from those sales will be, but do so keeping in mind Mr. Buffett’s maxim on investing:
Rule No. 1
Never lose money
Rule No. 2
Never forget Rule No. 1
Obviously, he, we, or anyone else can
lose money on an investment, but the point is that
in calculating the odds of success paying close
attention to risk is imperative. Given how hard it
is to accumulate investment capital – you need to go
to over 200 funerals before going to one where the
person was worth more than $2 million including real
estate – keeping what you have is key part of the
analysis of any investment.
It is the need to predict the future that also causes there to always seem to be mathematically oriented and computer driven investment strategies around where the promises turn out to be better than the realities. One great description of how these strategies can go wrong is in Roger Lowenstein’s book “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” There are lots of other examples. We feel the reason why is that, at least in investments, mathematics and computers are not good at “seeing where the puck is going” – rather, they analyze and make projections based on historical correlations which may, but often do not, hold going forward. Predicting the success of Costco, Visa or Berkshire Hathaway requires skill, work and judgement, but elementary school math is all you need.
As an aside, the venture capitalist Peter Thiel in “Zero on One: Notes on Startups, or How to Build the Future,” pointed out that:
Computers are far more different from people than any two people are different from each other: men and machines are good at fundamentally different things. People have intentionality – we form plans and make decisions in complicated situations. We’re less good at making sense of enormous amounts of data. Computers are exactly the opposite: they excel at efficient data processing, but they struggle to make basic judgements that would be simple for any human.
To understand the scale of this variance, consider another of Google’s computer-for-human substitution projects. In 2012, one of their supercomputers made headlines when, after scanning 10 million thumbnails of YouTube videos, it learned to identify a cat with 75% accuracy. That seems impressive, until you remember that an average four-year-old can do it flawlessly. When a cheap laptop beats the smartest mathematicians at some tasks but even a supercomputer with 16,000 CPUs can’t beat a child at others, you can tell that humans and computers are not just more or less powerful than each other – they’re categorically different.
Sir Isaac Newton quote on the movement of stars and the madness of men
That investing is more an art
than a science is hardly new, nor is companies
becoming way overvalued new -- Sir Isaac made his
comment after losing a bundle in the South Sea
Bubble. Whether you read “Titan” about John D.
Rockefeller or “Extraordinary Popular Delusions and
the Madness of Crowds” written in 1841, it is clear
that human psychology has not changed that much
today, if at all, from years ago, and crowd
psychology is unlikely to be mathematically
quantifiable. The upshot to the unpredictability of
crowd psychology is that we do not think we can
successfully time the market, and we do not think
anyone else can either.
We have often pointed out that the very good long term returns of stocks are concentrated in a startlingly small number of days in any given year or decade. A recent article in Barron’s made the point that “long term performance is surprisingly dependent on whether you were in the market in the five best days it has each year. A buy-and-hold strategy from 1900 through 2012 would have yielded stupendous returns. But if your timing was such that in each year you missed the five most profitable days, your long term returns would have been negative. A dollar invested in 1900 would have shrunk to a penny, which highlights the perils of jumping in and out of the market in the hope of maximizing gains.” Saying you can time the market is saying you can tell when the five best days will be in each year going forward – unlikely to happen. Malcolm Forbes once said that based on going to cocktail parties and hearing everyone say they were out when the market had a pull-back, he could never figure out how anyone was there for the hiccup!
Buffett’s bullishness on America and my question to him at the recent Berkshire Hathaway meeting
We think that the United States has a superior economic system and investing in American businesses has been an excellent strategy since the time of Benjamin Franklin and will continue to be a terrific approach for many decades to come. Even in 1776 Americans had the highest per capita income in the world – the system is really good! While we sometimes find businesses we invest in outside of America, we think investors should ask themselves a very simple question: If various emerging markets are such a great investment idea, then why are so many wealthy citizens of China, India, Brazil, and other places so eager to put their money here or in other established economies? For example, as illustrated in the book “The Big Dream,” some of the wealthiest folks in Brazil are eager to purchase American beer and food companies like Anheuser-Busch, Heinz, and Kraft.
We believe a simple strategy of owning a number of mostly American businesses, many of whom operate globally, where we are confident that they will sell plenty of products next year and going forward, thus generating ample resultant cash flows, is an approach that had flourished for a long time in the U.S. and should continue to do so for many decades going forward.
Warren Buffett has been very vocal for a long time in his very positive and bullish outlook for the American economy going forward. Prior to the Berkshire Hathaway meeting, you can submit questions to three famous business journalists, who each choose six to ask. I am actually 2 for 2, as last year my question on conglomerates was asked, and this year highly regarded print journalist Carol Loomis asked the following question I submitted in front of about 40,000 people: “Mr. Buffett, you have expressed your optimism about the future of America many times and have often made the point that the U.S. simply has a superior economic system. But my question to you concerns the risk of chemical, nuclear, biological, and cyber security problems, a combination you have sometimes dubbed CNBC. How do these threats affect your outlook?”
A short version of Mr. Buffett’s answer is that evidence of how we have a superior economic model can be found by looking at the U.S. and China in 1790. If you had flown over America that year, there was very little here and just 4 million people, while China, which is at the same latitude and thus has a somewhat comparable climate, had 290 million inhabitants. Yet over the following 200 years the U.S. economy grew to comprise close to 25% of global GDP. The system we founded a couple hundred years ago unlocks human potential. As to the CNBC weapons, Mr. Buffett feels the things that make the U.S. economy strong have not been mitigated by these threats, but we need an extremely vigilant security operation because there are lots of people who would like to do us harm. We agree.
No analysis of American competitive advantage is complete without noting that by giving women lots of opportunities (although gender disparities still do exist) the scientific, engineering, and business potential of our country is effectively doubled. There is every reason to think there are as many female Albert Einstein’s and Sir Isaac Newton’s in the future as male ones. In Walter Isaacson’s book “The Innovators” he details how computer software programming was largely invented and developed by women – there are endless additional examples!
In summary, we are very confident in betting on the Red, White, and Blue!
Nurture your flowers and cut your weeds
This could also be stated let your winners run and get rid of your losers. If you have a great business like Visa or Costco you should keep it for many years. Think about it this way – if Michael Jordan is on your basketball team would you trade him while he is still in his prime just because he had a shooting slump?
As to keeping the basketball players who can’t shoot, Mark Twain put it best: “A man who carries the cat by the tail learns something he can learn in no other way.”
Benjamin Graham quotes on business valuation
Regarding not needing to know a man’s weight to know he’s fat, we would restate this as do not ignore the obvious. If the parking lot of Costco is overflowing and everyone is moving away from cash to Visa, Master Card, and American Express, you do not need elaborate financial modeling to figure this out. As we pointed out earlier, elementary school math works just fine.
Also, folks forget that a stock is simply a percentage interest in a business – nothing else. Just because a company issues stock does not mean you do not need to ask the same basic questions you would pose if you considered buying a local business. Let’s hypothetically say you were considering buying a 7-Eleven store – you’d ask what the sales are, how much cash is generated, how long the lease runs, etc. If you saw lots of sales and low profits you might investigate whether the Slurpee proceeds were not making it into the cash register and such. We are regularly amazed at how often investors do not ask simple and basic questions when looking at a stock that they would never ever not ask if they bought a local business. For example, if (like many large technology firms) said 7-Eleven did not expense options, and the 7-Eleven seller said “oh, this expense doesn’t count,” you’d dismiss that assertion as preposterous, and count that expense in your analysis. However, somehow issues like this magically change in the eyes of many investors when considering whether to buy the shares of a publicly traded company. By the same token, if you had a 7-Eleven or really any terrific business gushing cash to you, we seriously doubt you would sell it just because you read of this or that macro event. The same should go for stocks.
We contend good investing is businesslike and does not allow these types of mistakes to happen.
Peter Lynch quotes on keeping things simple
We think you should be able to describe any top-notch investment in a few short and pithy sentences. A great business should be easy to understand, and, as Peter Lynch notes, simple to run. A good example is our investment in Visa. We wrote to you in 2011 that:
Growth in using “plastic” to pay for things also is likely to be a trend for many years to come, even more so outside of the United States. Visa provides essentially a royalty interest on the sales of businesses – this is a wonderful hedge against inflation/currency depreciation – and as the largest issuer of cards by far, Visa benefits mightily as folks migrate to electronic payments. Visa takes no credit risk, functions as a transaction processor, and makes its money off a quite small spread (surprisingly tiny in fact) on each transaction, which we judge is unlikely to go down much. This is in contrast to the bank issuers’ fees and interest rates which governments may easily continue to focus on. We think the excellent overall revenue increase that Visa has achieved since 2008, despite tough economic conditions, shows how strong their business is as well as the strength of the move towards using “plastic” to pay.
In our opinion, this
analysis remains true today. We would add only that
Visa’s business continues to do quite well as people
pay with electronic devices which then link to Visa.
Baron Rothschild quote on when to sell
We would say you are almost never going to catch the exact bottom and trying to get the last dollar calls to mind the saying – “Pigs get fat and hogs get slaughtered.”
Interestingly enough, all the short-term trading in the market we feel creates more opportunities for us as there are fewer investors who want to hold for the long-term and who are searching for long lasting competitive advantages.
Sir John Templeton quotes on independent thinking
It is a well-known principal of cognitive psychology that people think differently in groups, and as Anatole France said: “If fifty million people say a foolish thing, it is still a foolish thing.” Superior investing requires independent thinking; formulas do not work.
A good example of what can go wrong when there is not independent thinking is so many of the largest banks and brokerage firms going bust or needing government bailouts in 2008 and 2009. One suspects the senior managements of these companies spent far too much time copying one another, lunching together, and not thinking independently.
We would be surprised if anyone who has ever met either of us (Norman and Chris) thinks we lack independent points of view – as to tact and diplomacy …
It should be noted that with all that is written on investing, what is seldom discussed is perhaps the most important quality for success, which is emotional stability and maintaining a psychological distance regarding investments – without this, investment success is unlikely.
Warren Buffett quote on bonds
Regarding bonds, on a risk-to-reward basis, buying them now is akin to darting in front of a steam roller or a train to pick up a nickel! In our view, the extra income is not worth the risk. Bonds right now remind us of the Hemingway comment on how a man goes bankrupt: “Gradually, then suddenly.”
To state the obvious, interest rates are extremely low right now. Lots of wealthy families coming into the late 1960s were not feeling all that wealthy by the mid-1980s, yet they had not lost money, just a lot of purchasing power. It is imperative to invest keeping in mind that the purchasing power of a dollar has gone down a lot and likely will continue to decline – recently Chris found his Mom’s hospital bill from the 1960’s when he was born – the room in a top hospital cost $27. The examples are endless, but the takeaway is money needs to grow to keep up with inflation and the decline of a dollar’s purchasing power has not gotten in the way of overall prosperity increasing dramatically. Of course, if your money has not grown over time, the drop in a dollar’s purchasing power certainly has reduced your prosperity, perhaps a lot.
There have been only a few great bond bull markets in American history – this one started in 1981 and with only a few “blips” continues – there is not much room for rates to go down, but plenty of room for rates to rise. An insatiable thirst for yields has driven bond investors all over the world into riskier and riskier credits at lower and lower yields. When we see the low interest rates countries like Mongolia, Tunisia, Lebanon or many others issue debt at, not to mention financially challenged companies, or such things as the recent 100 year bonds of Mexico at what we deem to be a totally inadequate interest rate, we think, as John McEnroe titled his book, “You Cannot be Serious.”
We surmise that a lot of folks who have flocked into the bond market haven’t read a speech Ben Bernanke gave prior to becoming Fed Chairman in which he said: “The U.S. government has a technology called a printing press that allows it to produce as many U.S. dollars as it wishes at essentially no cost.” Alan Greenspan has pointed out that historically there are no cases where central banks have really ramped up their balance sheets or countries printed lots of money where higher inflation did not hit. Mr. Buffett recently said that he would not have guessed the U.S. government could have printed all this money for the past six years and had almost no inflation – we too find this surprising, but just because it has not happened yet does not mean it won’t.
We continue to find businesses to invest in at what we think are attractive entry points. We do not have anything against bonds, but yields are remarkably low, in fact negative in some European countries, and given all the government money printing both here and abroad, rates could rise significantly, creating perhaps large losses for bondholders.
In the early 1900’s a reporter asked J.P. Morgan what he thought stock prices would do and he replied: “They will fluctuate.” What we think you can do is invest in good businesses at attractive prices, thus hopefully creating a margin of safety, and then, whether you’re weighing the effect of international news or deciding when to invest, as Charlie Munger says: “The big money is not in the buying and selling, but in the waiting.”
As always, please call or email with any questions you have and please read the important cautionary language on the next page.