Chris Gottscho, Portfilio Manager

Report on the Berkshire Meeting and Thoughts on the Future of Value Investing

— by Chris Gottscho

A number of years ago, Warren Buffett implemented a vetting system to improve the quality of questions at the annual Berkshire Hathaway meeting. Under this system, shareholders are invited to submit their questions in advance to three renowned journalists, who screen the submissions and select six questions each to pose to Mr. Buffett. I’m quite pleased to report that for the third year in a row, a question I submitted was selected and asked at the annual meeting. Of course, asking the right questions is a key to investment success.

The backdrop to my question is that despite commentary from politicians, we feel that American business is thriving, that measures such as profitability and returns on capital are superb, and that the U.S. markets are likely to stay strong for the next 50-plus years. However, we recognize that a successful attack by a weapon of mass destruction could be disastrous if the government isn’t properly prepared to ensure the country continues to do well afterwards. Although we believe that American business is remarkably resilient and adaptive, we do think there is room for more preparation.

Carol Loomis, a very highly regarded business journalist, asked my question, as follows:

This question comes from Chris Gottscho of New York. Mr. Buffett, you have expressed concern about cyber, biological, nuclear, and chemical attacks. But preventing catastrophe is not getting enough attention. For example, a bill passed the House unanimously to harden the electric grid against a high altitude nuclear explosion. Not too many bills pass unanimously these days, but then, the bill got bottled up in the Senate. Have you ever considered funding – would it be a good idea for you to fund – a lobbying and educational campaign to promote the public good in this area and counteract industry lobbyists who are more interested in short-term profits?

Mr. Buffett responded at some length that there is no problem remotely like the issue of what he calls “CNBC:” 1 cyber, nuclear, biological, or chemical attacks, and that if a successful attack happens over the next several decades, and he thinks one will, he hopes that the damage is minimized. He then stated that if he knew how to reduce the probability of a CNBC-type mass attack “by 5%, all my money would go to that.” We think billions of dollars directed to a lobbying and educational campaign would reduce the odds by a lot more than 5%, so let’s hope that upon reflection Mr. Buffett thinks the same and perhaps the question spurs some action. (If you know any individuals with deep pockets and a thirst for a cause, this is an important one to mention.)

What this reminds us is that investing is about setting probabilities. Given the resiliency and adaptiveness of American business, we feel that our businesses and our markets would recover from and continue to thrive beyond a successful CNBC attack. Simply put, we believe that there has never been a better time to be alive on the planet and in America. Our country has had a fantastic business environment since the early 1600’s – even in 1776 Americans had the highest per capita income in the world. Since my Dad arrived from Germany in 1938, America’s standard of living per capita is up over six times. At the present time, entrepreneurial activity and technological innovation in America are robust. The eagerness of folks from China, India, Brazil, and elsewhere both to immigrate to the U.S. as well as to invest here is ample confirmation of the superiority of our economic system. We also believe that the diversity and inclusiveness of our work force widen our competitive advantages over other countries. While we are mindful of the fact that not all Americans are benefitting equally from the success of American businesses, and understand that this is a real challenge for our policy makers to address, we believe that it’s easier to meet this challenge in a climate of economic strength than it is in a climate of economic weakness.

So how does our optimistic view of American business translate to managing investments?

First, we find some thoughts Mr. Buffett expressed earlier this year on the investment markets bear repeating.

  • For those who are worried about 2016’s fluctuations, he advised: “I would tell them don’t watch the market closely and that buy and hold is the best strategy." In addition, he pointed out: “If they’re trying to buy and sell stocks and worry when they go down a little bit … and think they should maybe sell them when they go up, they’re not going to have very good results.”

    Given the constant news cycle, this is much easier said than done, but we feel it is superb advice.
     
  • On bonds, Mr. Buffett said: “If I had an easy way of shorting a whole lot of 20- or 30- year bonds, I’d do it, but that is not my game … I think that bonds are very overvalued.”

    Totally aside from credit risk (which we think is far more significant that folks realize), 2 interest rates going up can be disastrous for bond values. Increasingly issuers are selling 40-, 50-, and even 100-year bonds. Germany is a top-notch credit, but last year the 30-year bund lost a quarter of its value in two months when interest rates rose. One observer has pointed out that 64% of all money managers have never seen the Federal Reserve raise interest rates even once.

Furthermore, we continue to have great faith in “value investing” – buying businesses for substantially less than they are worth and holding them long-term. Norman’s good friend, Irving Kahn, was Ben Graham’s teaching assistant at Columbia Business School in the early 1930’s, around the time that Graham, along with David Dodd, wrote Security Analysis, a seminal work on value investing. Security Analysis is a framework of thinking that at its core focuses on the importance of what you pay for a business – your margin of safety. While some folks have suggested that this approach no longer is relevant in today’s markets, we could not disagree more. We believe Berkshire stock, at its current bargain valuation, is a great illustration of our investment philosophy, although a value analysis can find many other bargains in the current market as the herd looks elsewhere.

To us it seems obvious that what you pay for a business is critical. The recent stock price performance of Berkshire has prompted suggestions that Mr. Buffett and Mr. Munger have lost their “touch,” and that technological trends have made things like free cash flow much less important. We feel loading up with too many companies that have little or no free cash flow, earnings, or likely returns on capital going forward is akin to putting too much junk in your trunk – your axle might break. Simply because others are filling their trunks with what we feel is dubious merchandise, and have been for a few years, doesn’t make paying high prices for “junky” businesses a good idea, especially if it means selling a solid business like Berkshire at a cheap value to have cash in order to follow this trend. As Mark Twain said, “There are two times in a man's life when he should not speculate -- when he can’t afford it, and when he can.”

In addition, we think the protracted period of ultralow and even negative interest rates skews investor money flows as desperate investors chase higher returns by going into areas whose value characteristics seem to us to be questionable at best. Historically the crowd all following each other tends to work until it doesn’t. Group think by investors is hardly new – it has taken place in the past and is a fundamental part of human psychology. Reading Titan about John D. Rockefeller or other books about the history of business and investment markets, one thing that stands out is that while technology changes, human psychology stays the same. Herd behavior has been exacerbated by the extended low interest rates, but it hardly signals the demise of value investing.

In most cases the biggest risk to a business today is from technological change – this will only accelerate. Three excellent books on the potential changes coming in business are The Industries of the Future by Alec Ross, The Second Machine Age by Erik Brynjolfson and Andrew McAfee, and The Third Wave by Steve Case. As Reid Hoffman, the co-founder of LinkedIn, wrote regarding the Ross book: “The next 20 years are going to be even faster-moving and more transformative than the 20 we have just lived through. Predicting exactly what is going to happen is impossible. But thinking systematically and strategically … about robotics, genomics, and the codification of everything is absolutely critical.”

In our view, the wide variety of businesses that make up Berkshire -- bricks, chocolate, ice cream, railroads, and the like -- are far better protected from technology-driven challenges than the average publicly traded business in the U.S. Yet Berkshire stock trades at a big discount on various valuation metrics to the average company. To us, this is nonsensical. We believe that one reason for this disconnect is the age of Messrs. Buffett and Munger. However, even if they both pass away tomorrow,3 we think that Berkshire’s various holdings will continue to produce prodigious free cash flow that goes back to Omaha. Simply look at how Berkshire’s business has dramatically changed over the past 20 years from mostly owning publicly traded stocks to now being mostly made up of wholly owned businesses. The massive free cash flow it took to accomplish this transformation is unlikely to stop when Messrs. Buffett and Munger leave. But as Voltaire said: “Common sense is not so common.”

So how, one might ask, could Berkshire stock be down a double-digit percentage last year, while its businesses are generally doing well, with book value rising over the prior year? As Mr. Buffett said earlier in his career: “I think it is very easy to see what is likely to happen over the long term. Ben Graham told us why: ‘Though the stock market functions as a voting machine in the short run, it acts as a weighing machine in the long run.’ Fear and greed play important roles when votes are being cast, but they don’t register on the scale.” Mr. Buffett also said: “Ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham and Dodd will continue to prosper.”

We submit that although it might be popular to think that this period in investing history is somehow unique, value investing, just like American business, is still the best way to create long-term wealth.


1 Perhaps not surprisingly, Becky Quick from CNBC later asked Mr. Buffett to think of a new acronym!

2 We follow the bond markets closely, and know that debtors find themselves unable to pay far more often than many people realize. If you’d like an excellent cure for insomnia, please read Debt-Equity Swap Investing of Third World Investments: Will the I.R.S. Hinder U.S. Swappers written by a certain Chris Gottscho in the Virginia Tax Review in 1988 about the aftermath of investors thinking “this time it’s different” in an area of lending.

3 We hope that like Irving Kahn, Messrs. Buffett and Munger are lucky enough to manage money til they’re 109!

This letter contains the current opinions of the authors and Norman Fields, Gottscho Capital Management, LLC; such opinions are subject to change without notice. This email is distributed for informational purposes only. References to particular investments or types of investments are for illustrative purposes only and are not recommendations to buy or sell such investments. Nor are these references indicative in any way of performance returns in the accounts we manage. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as a recommendation of a particular security, strategy, or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.

Past performance is not a guarantee or a reliable indicator of future results. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Bonds may decline in value due to market, interest rate, issuer, credit, and inflation risk. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Commodities contain heightened risk including market, political, regulatory, and natural conditions. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate his or her ability to invest long-term, especially during periods of downturn in the market.
Norman Fields, Gottscho Capital Management, LLC
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