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Art of Stock Picking
By Charlie Munger, (Warren Buffett's partner at Berkshire Hathaway)
I'm going to play a minor trick on you today
because the subject of my talk is the art of stock picking as a
subdivision of the art of worldly wisdom. That enables me to start
talking about worldly wisdom a much broader topic that interests me
because I think all too little of it is delivered by modern
educational systems, at least in an effective way.
And therefore, the talk is sort of along the lines that some
behaviorist psychologists call Grandma's rule after the wisdom of
Grandma when she said that you have to eat the carrots before you
get the dessert.
The carrot part of this talk is about the general subject of
worldly wisdom which is a pretty good way to start. After all, the
theory of modern education is that you need a general education before you specialize.And
I think to some extent, before you're going to be a great stock
picker, you need some general education.
So, emphasizing what I sometimes waggishly call remedial worldly wisdom, I'm going to start by waltzing you
through a few basic notions.
What is elementary, worldly wisdom? Well, the first rule is that
you can't really know anything if you just remember isolated facts
and try and bang 'em back. If the facts don't hang together on a
latticework of theory, you don't have them in a usable form.
You've got to have models in your head. And you've
got to array your experience both vicarious and direct on
this latticework of models. You may have noticed students who just
try to remember and pound back what is remembered. Well, they fail
in school and in life. You've got to hang experience on a
latticework of models in your head.
What are the models? Well, the first rule is that you've got to
have multiple models because if you just have one
or two that you're using, the nature of human psychology is such
that you'll torture reality so that it fits your
models, or at least you'll think it does. You become the equivalent
of a chiropractor who, of course, is the great boob in
medicine.
It's like the old saying, "To the man with only a hammer, every
problem looks like a nail. "And of course, that's the way the
chiropractor goes about practicing medicine. But that's a perfectly
disastrous way to think and a perfectly disastrous way to operate
in the world. So you've got to have multiple models.
And the models have to come from multiple disciplines because all
the wisdom of the world is not to be found in one little academic
department. That's why poetry professors, by and large, are so
unwise in a worldly sense. They don't have enough models in their
heads. So you've got to have models across a fair array of
disciplines.
You may say, "My God, this is already getting way too tough. "But,
fortunately, it isn't that tough because 80 or 90
important models will carry about 90% of the freight in making you
a worldly wise person. And, of those, only a mere handful really
carry very heavy freight.
So let's briefly review what kind of models and techniques
constitute this basic knowledge that everybody has to have before
they proceed to being really good at a narrow art like stock
picking.
First there's mathematics. Obviously, you've got to be able to
handle numbers and quantities basic arithmetic. And the great
useful model, after compound interest, is the elementary math of
permutations and combinations. And that was taught in my day in the
sophomore year in high school. I suppose by now in great
private schools, it's probably down to the eighth grade or
so.
It's very simple algebra. It was all worked out in the course of
about one year between Pascal and Fermat. They worked it out
casually in a series of letters.
It's not that hard to learn. What is hard is to get so you use it
routinely almost everyday of your life. The Fermat/Pascal system is
dramatically consonant with the way that the world works. And it's
fundamental truth. So you simply have to have the technique.
Many educational institutions ‑ although not nearly enough have
realized this. At Harvard Business School, the great quantitative
thing that bonds the first year class together is what they call
decision tree theory. All they do is take high school algebra and
apply it to real life problems. And the students love it. They're
amazed to find that high school algebra works in life....
By and large, as it works out, people can't naturally and
automatically do this. If you understand elementary psychology, the
reason they can't is really quite simple: The basic neural network
of the brain is there through broad genetic and cultural evolution.
And it's not Fermat / Pascal. It uses a very crude, shortcut type
of approximation. It's got elements of Fermat / Pascal in it.
However, it's not good.
So you have to learn in a very usable way this very elementary math
and use it routinely in life ‑ just the way if you want to become a
golfer, you can't use the natural swing that broad evolution gave
you. You have to learnto have a certain grip and
swing in a different way to realize your full potential as a
golfer.
If you don't get this elementary, but mildly unnatural, mathematics
of elementary probability into your repertoire, then you go through
a long life like a one‑legged man in an ass‑kicking contest.
You're giving a huge advantage to everybody
else.
One of the advantages of a fellow like Buffett, whom I've worked
with all these years, is that he automatically
thinks in terms of decision trees and the elementary math of
permutations and combinations....
Obviously, you have to know accounting. It's the language of
practical business life. It was a very useful thing
to deliver to civilization. I've heard it came to civilization
through Venice which of course was once the great commercial power
in the Mediterranean. However, double-entry bookkeeping was a hell
of an invention.
And it's not that hard to understand.
But you have to know enough about it to understand its limitations
‑ because although accounting is the starting place, it's only a
crude approximation. And it's not very hard to understand its
limitations. For example, everyone can see that you have to more or
less just guess at the useful life of a jet airplane or anything
like that. Just because you express the depreciation rate in neat
numbers doesn't make it anything you really know.
In terms of the limitations of accounting, one of my favorite
stories involves a very great businessman named Carl Braun who
created the CF Braun Engineering Company. It designed and built oil
refineries ‑ which is very hard to do. And Braun would get them to
come in on time and not blow up and have efficiencies and so
forth. This is a major art.
And Braun, being the thorough Teutonic type that he was, had a
number of quirks. And one of them was that he took a look at
standard accounting and the way it was applied to building oil
refineries and he said, "This is asinine."
So he threw all of his accountants out and he took his engineers
and said, "Now, we'll devise our own system of
accounting to handle this process. "And in due time, accounting
adopted a lot of Carl Braun's notions. So he was a formidably
willful and talented man who demonstrated both the importance of
accounting and the importance of knowing its limitations.
He had another rule, from psychology, which, if you're interested
in wisdom, ought to be part of your repertoire ‑ like the
elementary mathematics of permutations and combinations.
His rule for all the Braun Company's communications was called the
five W's ‑ you had to tell who was going to do
what, where, when and why.And if
you wrote a letter or directive in the Braun Company telling
somebody to do something, and you didn't tell him why, you could
get fired. In fact, you would get fired if you did it twice.
You might ask why that is so important? Well, again that's a rule
of psychology. Just as you think better if you array knowledge on
a bunch of models that are basically answers to the question,
why, why, why, if you always tell people why,
they'll understand it better, they'll consider it more important,
and they'll be more likely to comply. Even if they don't understand
your reason, they'll be more likely to comply.
So there's an iron rule that just as you want to start getting
worldly wisdom by asking why, why, why, in communicating with other
people about everything, you want to include why, why, why. Even if
it's obvious, it's wise to stick in the why.
Which models are the most reliable? Well, obviously, the models
that come from hard science and engineering are the most reliable
models on this Earth. And engineering quality control ‑ at least
the guts of it that matters to you and me and people who are not
professional engineers ‑ is very much based on the elementary
mathematics of Fermat and Pascal:
It costs so much and you get so much less likelihood of it breaking
if you spend this much. It's all elementary high school
mathematics. And an elaboration of that is what Deming brought to
Japan for all of that quality control stuff.
I don't think it's necessary for most people to be terribly facile
in statistics. For example, I'm not sure that I can even pronounce
the Poisson distribution. But I know what a Gaussian or normal
distribution looks like and I know that events and huge aspects of
reality end up distributed that way. So I can do a rough
calculation.
But if you ask me to work out something involving a Gaussian
distribution to ten decimal points, I can't sit down and do the
math. I'm like a poker player who's learned to play pretty well
without mastering Pascal.
And by the way, that works well enough. But you have to understand
that bell‑shaped curve at least roughly as well as I do.
And, of course, the engineering idea of a backup system is a very
powerful idea. The engineering idea of breakpoints that's a very
powerful model, too. The notion of a critical mass that comes out
of physics is a very powerful model.
All of these things have great utility in looking at ordinary
reality. And all of this cost-benefit analysis ‑ hell, that's all
elementary high school algebra, too. It's just been dolled up a
little bit with fancy lingo.
I suppose the next most reliable models are from biology/
physiology because, after all, all of us are programmed by our
genetic makeup to be much the same.
And then when you get into psychology, of course, it gets very much
more complicated. But it's an ungodly important subject if you're
going to have any worldly wisdom.
And you can demonstrate that point quite simply: There's not a
person in this room viewing the work of a very ordinary
professional magician who doesn't see a lot of things happening
that aren't happening and not see a lot of things happening that
are happening.
And the reason why is that the perceptual apparatus of man has
shortcuts in it. The brain cannot have unlimited circuitry. So
someone who knows how to take advantage of those shortcuts and
cause the brain to miscalculate in certain ways can cause you to
see things that aren't there.
Now you get into the cognitive function as distinguished from the
perceptual function. And there, you are equally more than
equally in fact likely to be misled. Again, your brain has a
shortage of circuitry and so forth and it's taking all kinds of
little automatic shortcuts.
So when circumstances combine in certain ways or more commonly,
your fellow man starts acting like the magician and manipulates you
on purpose by causing your cognitive dysfunction you're a
patsy.
And so just as a man working with a tool has to know its
limitations, a man working with his cognitive apparatus has to know
its limitations. And this knowledge, by the way, can be used to
control and motivate other people....
So the most useful and practical part of psychology which I
personally think can be taught to any intelligent person in a week
is ungodly important. And nobody taught it to me by the way. I had
to learn it later in life, one piece at a time. And it was fairly
laborious. It's so elementary though that, when it was all over, I
felt like a fool.
And yeah, I'd been educated at Cal Tech and the Harvard Law School
and so forth. So very eminent places mis-educated people like you
and me.
The elementary part of psychology ‑ the psychology of misjudgment,
as I call it is a terribly important thing to learn. There are
about 20 little principles. And they interact, so it gets slightly
complicated. But the guts of it is unbelievably important.
Terribly smart people make totally bonkers mistakes by failing to
pay heed to it. In fact, I've done it several times during the last
two or three years in a very important way. You never get totally
over making silly mistakes.
There's another saying that comes from Pascal which I've always
considered one of the really accurate observations in the history
of thought. Pascal said in essence, "The mind of man at one and
the same time is both the glory and the shame of the
universe."
And that's exactly right. It has this enormous power. However, it
also has these standard malfunctions that often cause it to reach
wrong conclusions. It also makes man extraordinarily subject to
manipulation by others. For example, roughly half of the army of
Adolf Hitler was composed of believing Catholics. Given enough
clever psychological manipulation, what human beings will do is
quite interesting.
Personally, I've gotten so that I now use a kind of two-track
analysis. First, what are the factors that really govern the
interests involved, rationally considered? And
second, what are the subconscious influences where
the brain at a subconscious level is automatically doing these
things which by and large are useful, but which often
malfunction.
One approach is rationality the way you'd work out a bridge
problem: by evaluating the real interests, the real probabilities
and so forth. And the other is to evaluate the psychological
factors that cause subconscious conclusions many of which are
wrong.
Now we come to another somewhat less reliable form of human wisdom
microeconomics. And here, I find it quite useful to think of a free
market economy or partly free market economy as sort of the
equivalent of an ecosystem....
This is a very unfashionable way of thinking because early in the
days after Darwin came along, people like the robber barons assumed
that the doctrine of the survival of the fittest authenticated them
as deserving power you know, "I'm the richest. Therefore, I'm the
best. God's in his heaven, etc."
And that reaction of the robber barons was so irritating to people
that it made it unfashionable to think of an economy as an
ecosystem. But the truth is that it is a lot like an ecosystem. And
you get many of the same results.
Just as in an ecosystem, people who narrowly specialize can get
terribly good at occupying some little niche. Just as animals
flourish in niches, similarly, people who specialize in the
business world ‑ and get very good because they specialize
frequently find good economics that they wouldn't get any other
way.
And once we get into microeconomics, we get into the concept of
advantages of scale. Now we're getting closer to investment
analysis because in terms of which businesses succeed and which
businesses fail, advantages of scale are ungodly important.
For example, one great advantage of scale taught in all of the
business schools of the world is cost reductions along the
so-called experience curve. Just doing something complicated in
more and more volume enables human beings, who are trying to
improve and are motivated by the incentives of capitalism, to do it
more and more efficiently.
The very nature of things is that if you get a whole lot of volume
through your joint, you get better at processing that volume.
That's an enormous advantage. And it has a lot to do with which
businesses succeed and fail....
Let's go through a list albeit an incomplete one of possible
advantages of scale. Some come from simple geometry. If you're
building a great spherical tank, obviously as you build it bigger,
the amount of steel you use in the surface goes up with the square
and the cubic volume goes up with the cube. So as you increase the
dimensions, you can hold a lot more volume per unit area of
steel.
And there are all kinds of things like that where the simple
geometry the simple reality gives you an advantage of scale.
For example, you can get advantages of scale from TV advertising.
When TV advertising first arrived when talking color pictures first
came into our living rooms it was an unbelievably powerful thing.
And in the early days, we had three networks that had whatever it
was say 90% of the audience.
Well, if you were Proctor & Gamble, you could afford to use
this new method of advertising. You could afford the very expensive
cost of network television because you were selling so many cans
and bottles. Some little guy couldn't. And there was no way of
buying it in part. Therefore, he couldn't use it. In effect, if you
didn't have a big volume, you couldn't use network TV advertising
which was the most effective technique.
So when TV came in, the branded companies that were already big got
a huge tail wind. Indeed, they prospered and prospered and
prospered until some of them got fat and foolish, which happens
with prosperity ‑ at least to some people....
And your advantage of scale can be an informational advantage. If I
go to some remote place, I may see Wrigley chewing gum alongside
Glotz's chewing gum. Well, I know that Wrigley is a satisfactory
product, whereas I don't know anything about Glotz's. So if one is
40 cents and the other is 30 cents, am I going to take something I
don't know and put it in my mouth which is a pretty personal place,
after all for a lousy dime?
So, in effect, Wrigley , simply by being so well known, has
advantages of scale what you might call an informational
advantage.
Another advantage of scale comes from psychology. The psychologists
use the term “social proof”. We are all influenced subconsciously
and to some extent consciously by what we see others do and
approve. Therefore, if everybody's buying something, we think it's
better. We don't like to be the one guy who's out of step.
Again, some of this is at a subconscious level and some of it
isn't. Sometimes, we consciously and rationally think, "Gee, I
don't know much about this. They know more than I do. Therefore,
why shouldn't I follow them?"
The social proof phenomenon which comes right out of psychology
gives huge advantages to scale ‑ for example, with very wide
distribution, which of course is hard to get. One advantage of
Coca-Cola is that it's available almost everywhere
in the world.
Well, suppose you have a little soft drink. Exactly how do you make
it available all over the Earth? The worldwide distribution setup
which is slowly won by a big enterprise gets to be a huge advantage.... And if you think about it, once you get
enough advantages of that type, it can become very hard for anybody
to dislodge you.
There's another kind of advantage to scale. In some
businesses, the very nature of things is to sort of cascade toward
the overwhelming dominance of one firm.
The most obvious one is daily newspapers. There's practically no
city left in the U.S., aside from a few very big ones, where
there's more than one daily newspaper.
And again, that's a scale thing. Once I get most of the
circulation, I get most of the advertising. And once I get most of
the advertising and circulation, why would anyone want the thinner
paper with less information in it? So it tends to cascade to a
winner take all situation. And that's a separate form of the
advantages of scale phenomenon.
Similarly, all these huge advantages of scale allow greater
specialization within the firm. Therefore, each person can be
better at what he does.
And these advantages of scale are so great, for example, that when
Jack Welch came into General Electric, he just said, "To hell with
it. We're either going to be # 1 or #2 in every field we're in or
we're going to be out. I don't care how many people I have to fire
and what I have to sell. We're going to be #I or #2 or out."
That was a very tough‑minded thing to do, but I think it was a very
correct decision if you're thinking about maximizing shareholder
wealth. And I don't think it's a bad thing to do for a civilization
either, because I think that General Electric is stronger for
having Jack Welch there.
And there are also disadvantages of scale. For example, we by which
I mean Berkshire Hathaway ‑ are the largest shareholder in Capital
Cities /ABC. And we had trade publications there that got murdered
where our competitors beat us. And the way they beat us was by
going to a narrower specialization.
We'd have a travel magazine for business travel. So somebody would
create one which was addressed solely at corporate travel
departments. Like an ecosystem, you're getting a narrower and
narrower specialization.
Well, they got much more efficient. They could tell more to the
guys who ran corporate travel departments. Plus, they didn't have
to waste the ink and paper mailing out stuff that corporate travel
departments weren't interested in reading. It was a more efficient
system. And they beat our brains out as we relied on our broader
magazine.
That's what happened to The Saturday Evening Post
and all those things. They're gone. What we have now is Motorcross
which is read by a bunch of nuts who like to participate in
tournaments where they turn somersaults on their motorcycles. But
they care about it. For them, it's the principle purpose of life. A
magazine called Motorcross is a total necessity to those people.
Arid its profit margins would make you salivate.
Just think of how narrowcast that kind of publishing is. So
occasionally, scaling down and intensifying gives you the big
advantage. Bigger is not always better.
The great defect of scale, of course, which makes the game
interesting ‑ so that the big people don't always win ‑ is that as
you get big, you get the bureaucracy. And with the bureaucracy
comes the territoriality ‑ which is again grounded in human
nature.
And the incentives are perverse. For example, if you worked for
AT&T in my day, it was a great bureaucracy. Who in the hell was
really thinking about the shareholder or anything else? And in a
bureaucracy, you think the work is done when it goes out of your
in-basket into somebody else's in-basket. But, of course, it isn't.
It's not done until AT&T delivers what it's supposed to
deliver. So you get big, fat, dumb, unmotivated
bureaucracies.
They also tend to become somewhat corrupt. In other words, if I've
got a department and you've got a department and we kind of share
power running this thing, there's sort of an unwritten rule: "If
you won't bother me, I won't bother you and we're both happy. "So
you get layers of management and associated costs that nobody
needs. Then, while people are justifying all these layers, it takes
forever to get anything done. They're too slow to make decisions
and nimbler people run circles around them.
The constant curse of scale is that it leads to big, dumb
bureaucracy ‑ which, of course, reaches its highest and worst form
in government where the incentives are really awful. That doesn't
mean we don't need governments ‑ because we do. But it's a terrible
problem to get big bureaucracies to behave.
So people go to stratagems. They create little decentralized units
and fancy motivation and training programs. For example, for a big
company, General Electric has fought bureaucracy with amazing
skill. But that's because they have a combination of a genius and a
fanatic running it. And they put him in young enough so he gets a
long run. Of course, that's Jack Welch.
But bureaucracy is terrible.... And as things get very powerful and
very big, you can get some really dysfunctional behavior. Look at
Westinghouse. They blew billions of dollars on a bunch of dumb
loans to real estate developers. They put some guy who'd come up by
some career path ‑ I don't know exactly what it was, but it could
have been refrigerators or something ‑ and all of a sudden, he's
loaning money to real estate developers building hotels. It's a
very unequal contest. And in due time, they lost all those billions
of dollars.
CBS provides an interesting example of another rule of psychology
namely, Pavlovian association. If people tell you what you really
don't want to hear what's unpleasant there's an almost automatic
reaction of antipathy. You have to train yourself out of it. It
isn't foredestined that you have to be this way. But you will tend
to be this way if you don't think about it.
Television was dominated by one network ‑ CBS in its early days.
And Paley was a god. But he didn't like to hear what he didn't like
to hear. And people soon learned that. So they told Paley only what
he liked to hear. Therefore, he was soon living in a little cocoon
of unreality and everything else was corrupt although it was a
great business.
So the idiocy that crept into the system was carried along by this
huge tide. It was a Mad Hatter's tea party the last ten years under
Bill Paley.
And that is not the only example by any means. You can get severe
malfunction in the high ranks of business. And of course, if you're
investing, it can make a lot of difference. If you take all the
acquisitions that CBS made under Paley, after the acquisition of
the network itself, with all his advisors his investment bankers,
management consultants and so forth who were getting paid very
handsomely it was absolutely terrible.
For example, he gave something like 20% of CBS to the
Dumont Company for a television set manufacturer which was destined
to go broke. I think it lasted all of two or three years or
something like that. So very soon after he'd issued all of that
stock, Dumont was history. You get a lot of dysfunction in a big
fat, powerful place where no one will bring unwelcome reality to
the boss.
So life is an everlasting battle between those two forces ‑ to get
these advantages of scale on one side and a tendency to get a lot
like the U.S. Agriculture Department on the other side ‑ where
they just sit around and so forth. I don't know exactly what they
do. However, I do know that they do very little useful work.
On the subject of advantages of economies of scale, I find chain
stores quite interesting. Just think about it. The concept of a
chain store was a fascinating invention. You get this huge
purchasing power which means that you have lower merchandise costs.
You get a whole bunch of little laboratories out there in which you
can conduct experiments. And you get specialization.
If one little guy is trying to buy across 27 different merchandise
categories influenced by traveling salesmen, he's going to make a
lot of poor decisions. But if your buying is done in headquarters
for a huge bunch of stores, you can get very bright people that
know a lot about refrigerators and so forth to do the buying.
The reverse is demonstrated by the little store where one guy is
doing all the buying. It's like the old story about the little
store with salt all over its walls. And a stranger comes in and
says to the storeowner, "You must sell a lot of salt." And he
replies, "No, I don't. But you should see the guy who sells me salt."
So there are huge purchasing advantages. And then there are the
slick systems of forcing everyone to do what works. So a chain
store can be a fantastic enterprise.
It's quite interesting to think about Wal-Mart starting from a
single store in Bentonville, Arkansas against Sears, Roebuck with
its name, reputation and all of its billions. How does a guy in
Bentonville, Arkansas with no money blow right by Sears, Roebuck?
And he does it in his own lifetime ‑ in fact, during his own
late lifetime because he was already pretty old by
the time he started out with one little store....
He played the chain store game harder and better than anyone else.
Walton invented practically nothing.But he copied
everything anybody else ever did that was smart ‑ and he did it
with more fanaticism and better employee manipulation. So he just
blew right by them all.
He also had a very interesting competitive strategy in the early
days. He was like a prizefighter who wanted a great record so he
could be in the finals and make a big TV hit. So what did he do? He
went out and fought 42 palookas. Right? And the result was
knockout, knockout, knockout 42 times.
Walton, being as shrewd as he was, basically broke other small town
merchants in the early days. With his more efficient system, he
might not have been able to tackle some titan head-on at the time.
But with his better system, he could destroy those small town
merchants. And he went around doing it time after time after time.
Then, as he got bigger, he started destroying the big boys.
Well, that was a very, very shrewd strategy.
You can say, "Is this a nice way to behave? "Well, capitalism is a
pretty brutal place. But I personally think that the world is
better for having Wal-Mart. I mean you can idealize
small town life. But I've spent a fair amount of time in small
towns. And let me tell you ‑ you shouldn't get too idealistic about
all those businesses he destroyed.
Plus, a lot of people who work at Wal-Mart are very high grade,
bouncy people who are raising nice children. I have no feeling that
an inferior culture destroyed a superior culture. I think that is
nothing more than nostalgia and delusion. But, at any rate, it's an
interesting model of how the scale of things and fanaticism combine
to be very powerful.
And it's also an interesting model on the other side how with all
its great advantages, the disadvantages of bureaucracy did such
terrible damage to Sears, Roebuck. Sears had layers and layers of
people it didn't need. It was very bureaucratic. It was slow to
think. And there was an established way of thinking. If you poked
your head up with a new thought, the system kind of turned against
you. It was everything in the way of a dysfunctional big
bureaucracy that you would expect.
In all fairness, there was also much that was good about it. But it
just wasn't as lean and mean and shrewd and effective as Sam
Walton. And, in due time, all its advantages of scale were not
enough to prevent Sears from losing heavily to Wal-Mart and other
similar retailers.
Here's a model that we've had trouble with. Maybe you'll be able to
figure it out better. Many markets get down to two or three big
competitors or five or six. And in some of those markets, nobody
makes any money to speak of. But in others, everybody does very
well.
Over the years, we've tried to figure out why the competition in
some markets gets sort of rational from the investor's point of
view so that the shareholders do well, and in other markets,
there's destructive competition that destroys shareholder
wealth.
If it's a pure commodity like airline seats, you can understand why
no one makes any money. As we sit here, just think of what
airlines have given to the world safe travel, greater experience,
time with your loved ones, you name it. Yet, the net amount of
money that's been made by the shareholders of airlines since Kitty
Hawk, is now a negative figure ‑ a substantial negative figure.
Competition was so intense that, once it was unleashed by
deregulation, it ravaged shareholder wealth in the airline
business.
Yet, in other fields like cereals, for example almost all the big
boys make out. If you're some kind of a medium grade cereal maker,
you might make 15% on your capital. And if you're really good, you
might make 40%.But why are cereals so profitable despite the fact
that it looks to me like they're competing like crazy with
promotions, coupons and everything else? I don't fully understand
it.
Obviously, there's a brand identity factor in cereals that doesn't
exist in airlines. That must be the main factor that accounts for
it.
And maybe the cereal makers by and large have learned to be less
crazy about fighting for market share ‑ because if you get even
one person who's hell-bent on gaining market share.... For
example, if I were Kellogg and I decided that I had to have 60% of
the market, I think I could take most of the profit out of cereals.
I'd ruin Kellogg in the process. But I think I could do it.
In some businesses, the participants behave like a demented
Kellogg. In other businesses, they don't. Unfortunately, I do not
have a perfect model for predicting how that's going to
happen.
For example, if you look around at bottler markets, you'll find
many markets where bottlers of Pepsi and Coke both make a lot of
money and many others where they destroy most of the profitability
of the two franchises. That must get down to the peculiarities of
individual adjustment to market capitalism. I think you'd have to
know the people involved to fully understand what was
happening.
In microeconomics, of course, you've got the concept of patents,
trademarks, exclusive franchises and so forth. Patents are quite
interesting. When I was young, I think more money went into patents
than came out. Judges tended to throw them out based on arguments
about what was really invented and what relied on prior art. That
isn't altogether clear.
But they changed that. They didn't change the laws. They just
changed the administration ‑ so that it all goes to one patent
court. And that court is now very much more pro-patent. So I think
people are now starting to make a lot of money out of owning
patents.
Trademarks, of course, have always made people a lot of money. A
trademark system is a wonderful thing for a big operation if it's
well known.
The exclusive franchise can also be wonderful. If there were only
three television channels awarded in a big city and you owned one
of them, there were only so many hours a day that you could be
on.So you had a natural position in an oligopoly in the pre-cable
days.
And if you get the franchise for the only food stand in an
airport, you have a captive clientele and you have a small monopoly
of a sort.
The great lesson in microeconomics is to discriminate between when
technology is going to help you and when it's going
to kill you.And most people do not get this straight in their
heads. But a fellow like Buffett does.
For example, when we were in the textile business, which is a
terrible commodity business, we were making low-end textiles which
are a real commodity product. And one day, the people came to
Warren and said, "They've invented a new loom that we think will do
twice as much work as our old ones."
And Warren said, "Gee, I hope this doesn't work because if it does,
I'm going to close the mill." And he meant it.
What was he thinking? He was thinking, "It's a lousy business.
We're earning substandard returns and keeping it open just to be
nice to the elderly workers.B ut we're not going to put huge
amounts of new capital into a lousy business."
And he knew that the huge productivity increases that would come
from a better machine introduced into the production of a commodity
product would all go to the benefit of the buyers of the textiles.
Nothing was going to stick to our ribs as owners.
That's such an obvious concept ‑ that there are all kinds of
wonderful new inventions that give you nothing as owners except the
opportunity to spend a lot more money in a business that's still
going to be lousy. The money still won't come to you. All of the
advantages from great improvements are going to flow through to the
customers.
Conversely, if you own the only newspaper in Oshkosh and they were
to invent more efficient ways of composing the whole newspaper,
then when you got rid of the old technology and got new fancy
computers and so forth, all of the savings would come right through
to the bottom line.
In all cases, the people who sell the machinery ‑ and, by and
large, even the internal bureaucrats urging you to buy the
equipment show you projections with the amount you'll save at
current prices with the new technology. However, they don't do the
second step of the analysis which is to determine how much is going
stay home and how much is just going to flow through to the
customer. I've never seen a single projection incorporating that
second step in my life. And I see them all the time. Rather, they
always read: "This capital outlay will save you so much money that
it will pay for itself in three years."
So you keep buying things that will pay for themselves in three
years. And after 20 years of doing it, somehow you've earned a
return of only about 4% per annum. That's the textile
business.
And it isn't that the machines weren't better. It's just that the
savings didn't go to you. The cost reductions came through all
right. But the benefit of the cost reductions didn't go to the guy
who bought the equipment. It's such a simple idea. It's so basic.
And yet it's so often forgotten.
Then there's another model from microeconomics which I find very
interesting. When technology moves as fast as it does in a
civilization like ours, you get a phenomenon which I call
competitive destruction. You know, you have the finest buggy whip
factory and all of a sudden in comes this little horseless
carriage. And before too many years go by, your buggy whip business
is dead. You either get into a different business or you're dead ‑
you're destroyed. It happens again and again and again.
And when these new businesses come in, there are huge advantages for the early birds.And when you're an early
bird, there's a model that I call "surfing" ‑ when a surfer gets up
and catches the wave and just stays there, he can go a long, long
time. But if he gets off the wave, he becomes mired in
shallows....
But people get long runs when they're right on the edge of the
wave ‑ whether it's Microsoft or Intel or all kinds of people,
including National Cash Register in the early days.
The cash register was one of the great contributions to
civilization. It's a wonderful story. Patterson was a small retail
merchant who didn't make any money. One day, somebody sold him a
crude cash register which he put into his retail operation. And it
instantly changed from losing money to earning a profit because it
made it so much harder for the employees to steal....
But Patterson, having the kind of mind that he did, didn't think,
"Oh, good for my retail business." He thought, "I'm going into the
cash register business. "And, of course, he created National Cash
Register.
And he "surfed". He got the best distribution system, the biggest
collection of patents and the best of everything. He was a fanatic
about everything important as the technology developed. I have in
my files an early National Cash Register Company report in which
Patterson described his methods and objectives. And a well-educated
orangutan could see that buying into partnership with Patterson in
those early days, given his notions about the cash register
business, was a total 100% cinch.
And, of course, that's exactly what an investor should be looking
for. In a long life, you can expect to profit heavily from at least
a few of those opportunities if you develop the wisdom and will to
seize them. At any rate, "surfing" is a very powerful model.
However, Berkshire Hathaway , by and large, does not invest in
these people that are "surfing" on complicated technology. After
all, we're cranky and idiosyncratic ‑ as you may have
noticed.
And Warren and I don't feel like we have any great advantage in the
high-tech sector. In fact, we feel like we're at a big disadvantage
in trying to understand the nature of technical developments in
software, computer chips or what have you. So we tend to avoid that
stuff, based on our personal inadequacies.
Again, that is a very, very powerful idea. Every person is going to
have a circle of competence. And it's going to be very hard to
advance that circle. If I had to make my living as a musician.... I
can't even think of a level low enough to describe
where I would be sorted out to if music were the measuring standard
of the civilization.
So you have to figure out what your own aptitudes are. If you play
games where other people have the aptitudes and you don't, you're
going to lose. And that's as close to certain as any prediction
that you can make. You have to figure out where you've got an edge. And you've got to play within your
own circle of competence.
If you want to be the best tennis player in the world, you may
start out trying and soon find out that it's hopeless ‑ that other
people blow right by you. However, if you want to become the best
plumbing contractor in Bemidji, that is probably doable by
two-thirds of you. It takes a will.I t takes the intelligence. But
after a while, you'd gradually know all about the plumbing business
in Bemidji and master the art. That is an
attainable objective, given enough discipline. And people who could
never win a chess tournament or stand in center court in a
respectable tennis tournament can rise quite high in life by slowly
developing a circle of competence ‑ which results partly from what
they were born with and partly from what they slowly develop
through work.
So some edges can be acquired. And the game of life to some extent
for most of us is trying to be something like a good plumbing
contractor in Bemidji. Very few of us are chosen to win the world's
chess tournaments.
Some of you may find opportunities "surfing" along in the new
high-tech fields the Intels, the Microsofts and so on. The fact
that we don't think we're very good at it and have pretty well
stayed out of it doesn't mean that it's irrational for you to do
it.
Well, so much for the basic microeconomics models, a little bit of
psychology, a little bit of mathematics, helping create what I call
the general substructure of worldly wisdom. Now, if you want to go
on from carrots to dessert, I'll turn to stock picking ‑ trying to
draw on this general worldly wisdom as we go.
I don't want to get into emerging markets, bond arbitrage and so
forth. I'm talking about nothing but plain vanilla stock picking.
That, believe me, is complicated enough. And I'm talking about
common stock picking.
The first question is, "What is the nature of the stock market?"
And that gets you directly to this efficient market theory that got
to be the rage a total rage long after I graduated
from law school.
And it's rather interesting because one of the greatest economists
of the world is a substantial shareholder in Berkshire Hathaway and
has been for a long time. His textbook always taught that the stock
market was perfectly efficient and that nobody could beat it. But
his own money went into Berkshire and made him
wealthy. So, like Pascal in his famous wager, he hedged his
bet.
Is the stock market so efficient that people can't beat it? Well,
the efficient market theory is obviously roughly
right meaning that markets are quite efficient and
it's quite hard for anybody to beat the market by
significant margins as a stock picker by just being intelligent and
working in a disciplined way.
Indeed, the average result has to be the average result. By
definition, everybody can't beat the market. As I
always say, the iron rule of life is that only 20% of the people
can be in the top fifth. That's just the way it is. So the answer
is that it's partly efficient and partly inefficient.
And, by the way, I have a name for people who went to the extreme
efficient market theory which is "bonkers". It was an
intellectually consistent theory that enabled them to do pretty
mathematics. So I understand its seductiveness to people with large
mathematical gifts. It just had a difficulty in that the
fundamental assumption did not tie properly to reality.
Again, to the man with a hammer, every problem looks like a nail.
If you're good at manipulating higher mathematics in a consistent
way, why not make an assumption which enables you to use your
tool?
The model I like to sort of simplify the notion of what goes on in
a market for common stocks is the pari-mutuel system at the
racetrack. If you stop to think about it, a pari-mutuel system is a
market.Everybody goes there and bets and the odds
change based on what's bet. That's what happens in the stock
market.
Any damn fool can see that a horse carrying a light weight with a
wonderful win rate and a good post position etc., etc. is way more
likely to win than a horse with a terrible record and extra weight
and so on and so on.But if you look at the odds, the bad horse
pays 100 to 1, whereas the good horse pays 3 to 2.Then it's not
clear which is statistically the best bet using the mathematics of
Fermat and Pascal. The prices have changed in such a way that it's
very hard to beat the system.
And then the track is taking 17% off the top. So
not
only do you have to outwit
all the other betters, but you've got to outwit them by such a big
margin that on average, you can afford to take 17% of your gross
bets off the top and give it to the house before the rest of your
money can be put to work.
Given those mathematics, is it possible to beat the horses only
using one's intelligence? Intelligence should give some edge,
because lots of people who don't know anything go out and bet lucky
numbers and so forth. Therefore, somebody who really thinks about
nothing but horse performance and is shrewd and mathematical could
have a very considerable edge, in the absence of the frictional
cost caused by the house take.
Unfortunately, what a shrewd horseplayer's edge does in most cases
is to reduce his average loss over a season of betting from the 17%
that he would lose if he got the average result to maybe
10%.However, there are actually a few people who can beat the game
after paying the full 17%.
I used to play poker when I was young with a guy who made a
substantial living doing nothing but bet harness races.... Now,
harness racing is a relatively inefficient market. You don't have
the depth of intelligence betting on harness races that you do on
regular races. What my poker pal would do was to think about
harness races as his main profession. And he would bet only
occasionally when he saw some mispriced bet available. And by doing
that, after paying the full handle to the house ‑ which I presume
was around 17% ‑ he made a substantial living.
You have to say that's rare. However, the market was not perfectly
efficient. And if it weren't for that big 17% handle, lots of
people would regularly be beating lots of other people at the horse
races. It's efficient, yes. But it's not perfectly efficient. And
with enough shrewdness and fanaticism, some people will get better
results than others.
The stock market is the same way except that the house handle is so
much lower. If you take transaction costs ‑ the spread between the
bid and the ask plus the commissions and if you don't trade too
actively, you're talking about fairly low transaction costs. So
that with enough fanaticism and enough discipline, some of the
shrewd people are going to get way better results than average in
the nature of things.
It is not a bit easy. And, of course, 50% will end up in the bottom
half and 70% will end up in the bottom 70%.But some people will
have an advantage. And in a fairly low transaction cost operation,
they will get better than average results in stock picking.
How do you get to be one of those who is a winner ‑ in a relative
sense ‑ instead of a loser?
Here again, look at the pari-mutuel system. I had dinner last night
by absolute accident with the president of Santa Anita. He says
that there are two or three betters who have a credit arrangement
with them, now that they have off-track betting, who are actually
beating the house. They're sending money out net after the full
handle a lot of it to Las Vegas, by the way to people who are
actually winning slightly, net, after paying the full handle.
They're that shrewd about something with as much unpredictability
as horse racing.
And the one thing that all those winning betters in the whole
history of people who've beaten the pari-mutuel system have is
quite simple. They bet very seldom.
It's not given to human beings to have such talent that they can
just know everything about everything all the time. But it is given
to human beings who work hard at it ‑ who look and sift the world
for a mispriced be that they can occasionally find one.
And the wise ones bet heavily when the world offers them that
opportunity. They bet big when they have the odds. And the rest of
the time, they don't. It's just that simple.
That is a very simple concept. And to me it's obviously right based
on experience not only from the pari-mutuel system, but everywhere
else.
And yet, in investment management, practically nobody operates that
way. We operate that way ‑ I'm talking about Buffett and Munger.
And we're not alone in the world. But a huge majority of people
have some other crazy construct in their heads And instead of
waiting for a near cinch and loading up, they apparently ascribe to
the theory that if they work a little harder or hire more business
school students, they'll come to know everything about everything
all the time.
To me, that's totally insane. The way to win is to
work, work, work, work and hope to have a few insights.
How many insights do you need? Well, I'd argue: that you don't need
many in a lifetime. If you look at Berkshire Hathaway and all of
its accumulated billions, the top ten insights account for most of
it. And that's with a very brilliant man Warren's a lot more able
than I am and very disciplined devoting his lifetime to it. I don't
mean to say that he's only had ten insights. I'm just saying, that
most of the money came from ten insights.
So you can get very remarkable investment results if you think more
like a winning pari-mutuel player. Just think of it as a heavy odds
against game full of craziness with an occasional mispriced
something or other. And you're probably not going to be smart
enough to find thousands in a lifetime. And when you get a few, you
really load up. It's just that simple.
When Warren lectures at business schools, he says, "I could improve
your ultimate financial welfare by giving you a ticket with only
20 slots in it so that you had 20 punches ‑ representing all the
investments that you got to make in a lifetime. And once you'd
punched through the card, you couldn't make any more investments at
all."
He says, "Under those rules, you'd really think carefully about
what you did and you'd be forced to load up on what you'd really
thought about. So you'd do so much better."
Again, this is a concept that seems perfectly obvious to me. And to
Warren, it seems perfectly obvious. But this is one of the very few
business classes in the U.S. where anybody will be saying so. It
just isn't the conventional wisdom.
To me, it's obvious that the winner has to bet very selectively.
It's been obvious to me since very early in life. I don't know why
it's not obvious to very many other people.
I think the reason why we got into such idiocy in investment
management is best illustrated by a story that I tell about the guy
who sold fishing tackle. I asked him, "My God, they're purple and
green. Do fish really take these lures?" And he said, "Mister, I
don't sell to fish."
Investment managers are in the position of that fishing tackle
salesman. They're like the guy who was selling salt to the guy who
already had too much salt. And as long as the guy will buy salt,
why they'll sell salt. But that isn't what
ordinarily works for the buyer of investment
advice.
If you invested Berkshire Hathaway-style, it would be hard to get
paid as an investment manager as well as they're currently paid ‑
because you'd be holding a block of Wal-Mart and a block of
Coca-Cola and a block of something else. You'd just sit there. And
the client would be getting rich. And, after a while, the client
would think, "Why am I paying this guy half a percent a year on my
wonderful passive holdings?"
So what makes sense for the investor is different from what makes
sense for the manager. And, as usual in human affairs, what
determines the behavior are incentives for the decision
maker.
From all business, my favorite case on incentives is Federal
Express. The heart and soul of their system which creates the
integrity of the product is having all their airplanes come to one
place in the middle of the night and shift all the packages from
plane to plane. If there are delays, the whole operation can't
deliver a product full of integrity to Federal Express
customers.
And it was always screwed up. They could never get it done on
time. They tried everything moral suasion, threats, you name it.
And nothing worked.
Finally, somebody got the idea to pay all these people not so much
an hour, but so much a shift and
when it's all done, they can all go home. Well, their problems
cleared up overnight.
So getting the incentives right is a very, very important lesson.
It was not obvious to Federal Express what the solution was. But
maybe now, it will hereafter more often be obvious to you.
All right, we've now recognized that the market is efficient as a
pari-mutuel system is efficient with the favorite more likely than
the long shot to do well in racing, but not necessarily give any
betting advantage to those that bet on the favorite.
In the stock market, some railroad that's beset by better
competitors and tough unions may be available at one-third of its
book value. In contrast, IBM in its heyday might be selling at 6
times book value. So it's just like the pari-mutuel system. Any
damn fool could plainly see that IBM had better business prospects
than the railroad. But once you put the price into
the formula, it wasn't so clear anymore what was going to work best
for a buyer choosing between the stocks. So it's a lot like a
pari-mutuel system. And, therefore, it gets very hard to
beat.
What style should the investor use as a picker of common stocks in
order to try to beat the market ‑ in other words, to get an above
average long-term result? A standard technique that appeals to a
lot of people is called "sector rotation". You simply figure out
when oils are going to outperform retailers, etc., etc., etc. You
just kind of flit around being in the hot sector of the market
making better choices than other people. And presumably, over a
long period of time, you get ahead.
However, I know of no really rich sector rotator. Maybe some people
can do it. I'm not saying they can't. All I know is that all the
people I know who got rich and I know a lot of them did not do it
that way.
The second basic approach is the one that Ben Graham used much
admired by Warren and me. As one factor, Graham had this concept
of value to a private owner what the whole enterprise would sell
for if it were available. And that was calculable in many
cases.
Then, if you could take the stock price and multiply it by the
number of shares and get something that was one third or less of
sellout value, he would say that you've got a lot of edge going for
you.Even with an elderly alcoholic running a stodgy business, this
significant excess of real value per share working for you means
that all kinds of good things can happen to you. You had a
huge margin of safety ‑ as he put it ‑ by having
this big excess value going for you.
But he was, by and large, operating when the world was in shell
shock from the 1930s ‑ which was the worst contraction in the
English-speaking world in about 600 years. Wheat in Liverpool, I
believe, got down to something like a 600-year low, adjusted for
inflation. People were so shell-shocked for a long time thereafter
that Ben Graham could run his Geiger counter over this detritus
from the collapse of the 1930s and find things selling below their
working capital per share and so on.
And in those days, working capital actually belonged to the
shareholders. If the employees were no longer useful, you just
sacked them all, took the working capital and stuck it in the
owners' pockets. That was the way capitalism then worked.
Nowadays, of course, the accounting is not realistic because the
minute the business starts contracting, significant assets are not
there. Under social norms and the new legal rules of the
civilization, so much is owed to the employees that, the minute the
enterprise goes into reverse, some of the assets on the balance
sheet aren't there anymore.
Now, that might
not be true if you run a little auto dealership yourself. You may
be able to run it in such a way that there's no health plan and
this and that so that if the business gets lousy, you can take your
working capital and go home. But IBM can't, or at least didn't.
Just look at what disappeared from its balance sheet when it
decided that it had to change size both because the world had
changed technologically and because its market position had
deteriorated.
And in terms of blowing it, IBM is some example. Those were
brilliant, disciplined people. But there was enough turmoil in
technological change that IBM got bounced off the wave after
"surfing" successfully for 60 years. And that was some collapse an
object lesson in the difficulties of technology and one of the
reasons why Buffett and Munger don't like technology very much. We
don't think we're any good at it, and strange things can
happen.
At any rate, the trouble with what I call the classic Ben Graham
concept is that gradually the world wised up and those real obvious
bargains disappeared. You could run your Geiger counter over the
rubble and it wouldn't click.
But such is the nature of people who have a hammer ‑ to whom, as I
mentioned, every problem looks like a nail that the Ben Graham
followers responded by changing the calibration on their Geiger
counters. In effect, they started defining a bargain in a different
way. And they kept changing the definition so that they could keep
doing what they'd always done. And it still worked
pretty well. So the Ben Graham intellectual system was a very good
one.
Of course, the best part of it all was his concept of "Mr. Market".
Instead of thinking the market was efficient, he treated it as a
manic-depressive who comes by every day. And some days he says,
"I'll sell you some of my interest for way less than you think it's
worth." And other days, "Mr. Market" comes by and says, "I'll buy
your interest at a price that's way higher than you think it's
worth. "And you get the option of deciding whether
you want to buy more, sell part of what you already have or do
nothing at all.
To Graham, it was a blessing to be in business with a
manic-depressive who gave you this series of options all the time.
That was a very significant mental construct. And it's been very
useful to Buffett, for instance, over his whole adult
lifetime.
However, if we'd stayed with classic Graham the way Ben Graham did
it, we would never have had the record we have. And that's because
Graham wasn't trying to do what we did.
For example, Graham didn't want to ever talk to management. And his
reason was that, like the best sort of professor aiming his
teaching at a mass audience, he was trying to invent a system that
anybody could use. And he didn't feel that the man
in the street could run around and talk to managements and learn
things. He also had a concept that the management would often couch
the information very shrewdly to mislead. Therefore, it was very
difficult. And that is still true, of course human nature being
what it is.
And so having started out as Grahamites which, by the way, worked
fine we gradually got what I would call better insights. And we
realized that some company that was selling at 2 or 3 times book
value could still be a hell of a bargain because of
momentums implicit in its position, sometimes combined with an
unusual managerial skill plainly present in some individual or
other, or some system or other.
And once we'd gotten over the hurdle of recognizing that a thing
could be a bargain based on quantitative measures that would have
horrified Graham, we started thinking about better
businesses.
And, by the way, the bulk of the billions in Berkshire Hathaway
have come from the better businesses. Much of the first $200 or
$300 million came from scrambling around with our Geiger counter.
But the great bulk of the money has come from the great
businesses.
And even some of the early money was made by being temporarily
present in great businesses. Buffett Partnership, for example,
owned American Express and Disney when they got pounded down.
Most investment managers are in a game where the clients expect
them to know a lot about a lot of things. We didn't have any
clients who could fire us at Berkshire Hathaway. So we didn't have
to be governed by any such construct. And we came to this notion of
finding a mispriced bet and loading up when we were very confident
that we were right. So we're way less diversified. And I think our
system is miles better.
However, in all fairness, I don't think a lot of money managers
could successfully sell their services if they used our system. But
if you're investing for 40 years in some pension fund, what
difference does it make if the path from start to finish is a
little more bumpy or a little different than everybody else's so
long as it's all going to work out well in the end? So what if
there's a little extra volatility.
In investment management today, everybody wants not only to win,
but to have a yearly outcome path that never diverges very much
from a standard path except on the upside. Well, that is a very
artificial, crazy construct. That's the equivalent in investment
management to the custom of binding the feet of Chinese women. It's
the equivalent of what Nietzsche meant when he criticized the man
who had a lame leg and was proud of it.
That is really hobbling yourself. Now, investment managers would
say, "We have to be that way. That's how we're
measured. "And they may be right in terms of the
way the business is now constructed. But from the viewpoint of a
rational consumer, the whole system's "bonkers" and draws a lot of
talented people into socially useless activity.
And the Berkshire system is not "bonkers". It's so damned
elementary that even bright people are going to have limited,
really valuable insights in a very competitive world when they're
fighting against other very bright, hardworking people.
And it makes sense to load up on the very few good insights you
have instead of pretending to know everything about everything at
all times. You're much more likely to do well if you start out to
do something feasible instead of something that
isn't feasible. Isn't that perfectly obvious?
How many of you have 56 brilliant ideas in which you have equal
confidence? Raise your hands, please. How many of you have two or
three insights that you have some confidence in? I rest my
case.
I'd say that Berkshire Hathaway's system is adapting to the nature
of the investment problem as it really is.
We've really made the money out of high quality businesses. In some
cases, we bought the whole business. And in some cases, we just
bought a big block of stock. But when you analyze what happened,
the big money's been made in the high quality businesses. And most
of the other people who've made a lot of money have done so in high
quality businesses.
Over the long term, it's hard for a stock to earn a much better
return than the business which underlies it earns. If the business
earns 6% on capital over 40 years and you hold it for that 40
years, you're not going to make much different than a 6% return
even if you originally buy it at a huge discount. Conversely, if a
business earns 18% on capital over 20 or 30 years, even if you pay
an expensive looking price, you'll end up with a fine result.
So the trick is getting into better businesses. And that involves
all of these advantages of scale that you could consider momentum
effects.
How do you get into these great companies? One method is what I'd
call the method of finding them small get 'em when they're little.
For example, buy Wal-Mart when Sam Walton first goes public and so
forth. And a lot of people try to do just that. And it's a very
beguiling idea. If I were a young man, I might actually go into
it.
But it doesn't work for Berkshire Hathaway anymore because we've
got too much money. We can't find anything that fits our size
parameter that way. Besides, we're set in our ways. But I regard
finding them small as a perfectly intelligent approach for somebody
to try with discipline. It's just not something that I've
done.
Finding 'em big obviously is very hard because of the competition.
So far, Berkshire's managed to do it. But can we continue to do it?
What's the next Coca-Cola investment for us? Well, the answer to
that is I don't know. I think it gets harder for us all the
time....
And ideally and we've done a lot of this you get into a great
business which also has a great manager because management matters.
For example, it's made a great difference to General Electric that
Jack Welch came in instead of the guy who took over Westinghouse ‑
a very great difference. So management matters, too.
And some of it is predictable. I do not think it takes a genius to
understand that Jack Welch was a more insightful person and a
better manager than his peers in other companies. Nor do I think it
took tremendous genius to understand that Disney had basic
momentums in place which are very powerful and that Eisner and
Wells were very unusual managers.
So you do get an occasional opportunity to get into a wonderful
business that's being run by a wonderful manager. And, of course,
that's hog heaven day. If you don't load up when you get those
opportunities, it's a big mistake.
Occasionally, you'll find a human being who's so talented that he
can do things that ordinary skilled mortals can't. I would argue
that Simon Marks who was second generation in Marks & Spencer
of England was such a man. Patterson was such a man at National
Cash Register. And Sam Walton was such a man.
These people do come along and in many cases, they're not all that
hard to identify. If they've got a reasonable hand with the
fanaticism and intelligence and so on that these people generally
bring to the party then management can matter much.
However, averaged out, betting on the quality of a business is
better than betting on the quality of management. In other words,
if you have to choose one, bet on the business momentum, not the
brilliance of the manager.
But, very rarely. you find a manager who's so good that you're wise
to follow him into what looks like a mediocre business.
Another very simple effect I very seldom see discussed either by
investment managers or anybody else is the effect of taxes. If
you're going to buy something which compounds for 30 years at 15%
per annum and you pay one 35% tax at the very end, the way that
works out is that after taxes, you keep 13.3% per annum.
In contrast, if you bought the same investment, but had to pay
taxes every year of 35% out of the 15% that you earned, then your
return would be 15% minus 35% of 15% or only 9.75% per year
compounded. So the difference there is over 3.5%.And what 3.5% does
to the numbers over long holding periods like 30 years is truly
eye-opening. If you sit back for long, long stretches in great
companies, you can get a huge edge from nothing but the way that
income taxes work.
Even with a 10% per annum investment, paying a 35% tax at the end
gives you 8.3% after taxes as an annual compounded result after 30
years. In contrast, if you pay the 35% each year instead of at the
end, your annual result goes down to 6.5%.So you add nearly 2% of
after-tax return per annum if you only achieve an average return
by historical standards from common stock investments in companies
with tiny dividend payout ratios.
But in terms of business mistakes that I've seen over a long
lifetime, I would say that trying to minimize taxes too much is
one of the great standard causes of really dumb mistakes. I see
terrible mistakes from people being overly
motivated by tax considerations.
Warren and I personally don't drill oil wells. We pay our taxes.
And we've done pretty well, so far. Anytime somebody offers you a
tax shelter from here on in life, my advice would be don't buy
it.
In fact, any time anybody offers you anything with
a big commission and a 200-page prospectus, don't buy it.
Occasionally, you'll be wrong if you adopt "Munger's Rule".
However, over a lifetime, you'll be a long way ahead ‑ and you will
miss a lot of unhappy experiences that might otherwise reduce your
love for your fellow man.
There are huge advantages for an individual to get
into a position where you make a few great investments and just sit
back and wait: You're paying less to brokers. You're listening to
less nonsense. And if it works, the governmental tax system gives
you an extra 1, 2 or 3 percentage points per annum
compounded.
And you think that most of you are going to get that much advantage
by hiring investment counselors and paying them 1% to run around,
incurring a lot of taxes on your behalf'? Lots of luck.
Are there any dangers in this philosophy? Yes. Everything in life
has dangers. Since it's so obvious that investing in great
companies works, it gets horribly overdone from time to time. In
the "Nifty-Fifty" days, everybody could tell which companies were
the great ones. So they got up to 50, 60 and 70 times earnings.
And just as IBM fell off the wave, other companies did, too. Thus,
a large investment disaster resulted from too high prices. And
you've got to be aware of that danger....
So there are risks .Nothing is automatic and easy. But if you can
find some fairly-priced great company and buy it and sit, that
tends to work out very, very well indeed especially for an
individual,
Within the growth stock model, there's a sub-position: There are
actually businesses, that you will find a few times in a lifetime,
where any manager could raise the return enormously just by raising
prices and yet they haven't done it. So they have huge untapped pricing power that they're not using. That is
the ultimate no-brainer.
That existed in Disney. It's such a unique experience to take your
grandchild to Disneyland. You're not doing it that often .And there
are lots of people in the country. And Disney found that it could
raise those prices a lot and the attendance stayed right up.
So a lot of the great record of Eisner and Wells was utter
brilliance but the rest came from just raising prices at Disneyland
and Disneyworld and through video cassette sales of classic
animated movies.
At Berkshire Hathaway, Warren and I raised the prices of See's
Candy a little faster than others might have. And, of course, we
invested in Coca-Cola ‑ which had some untapped pricing power. And
it also had brilliant management. So a Goizueta and Keough could do
much more than raise prices.It was perfect.
You will get a few opportunities to profit from finding
underpricing. There are actually people out there who don't price
everything as high as the market will easily stand. And once you
figure that out, it's like finding in the street ‑ if you have the
courage of your convictions.
If you look at Berkshire's investments where a lot of the money's
been made and you look for the models, you can see that we twice
bought into two newspaper towns which have since become one
newspaper towns. So we made a bet to some extent....
In one of those The Washington Post we bought it at about 20% of
the value to a private owner. So we bought it on a Ben Graham style
basis at one fifth of obvious value and, in addition, we faced a
situation where you had both the top hand in a game that was
clearly going to end up with one winner and a management with a
lot of integrity and intelligence. That one was a real dream.
They're very high class people ‑ the Katharine Graham family.
That's why it was a dream an absolute, damn dream.
Of course, that came about back in '73 - 74.And that was almost
like 1932. That was probably a once-in-40-years type denouement in
the markets. That investment's up about 50 times over our
cost.
If I were you, I wouldn't count on getting any investment in your
lifetime quite as good as The Washington Post was in '73 and
'74.
But it doesn't have to be that good to take care of
you.
Let me mention another model. Of course, Gillette and Coke make
fairly low‑priced items and have a tremendous marketing advantage
all over the world. And in Gillette's case, they keep surfing along
new technology which is fairly simple by the standards of
microchips. But it's hard for competitors to do.
So they've been able to stay constantly near the edge of
improvements in shaving. There are whole countries where Gillette
has more than 90% of the shaving market.
GEICO is a very interesting model. It's another one of the 100 or
so models you ought to have in your head. I've had many friends in
the sick business fix up game over a long lifetime. And they
practically all use the following formula I call it the cancer
surgery formula:
They look at this mess. And they figure out if there ' s anything
sound left that can live on its own if they cut away everything
else. And if they find anything sound, they just cut away
everything else. Of course, if that doesn't work, they liquidate
the business. But it frequently does work.
And GEICO had a perfectly magnificent business
‑submerged in a mess, but still working. Misled by success, GEICO
had done some foolish things. They got to thinking that, because
they were making a lot of money, they knew everything. And they
suffered huge losses.
All they had to do was to cut out all the folly and go back to the
perfectly wonderful business that was lying there. And when you
think about it, that's a very simple model. And it's repeated over
and over again.
And, in GEICO's case, think about all the money we passively
made....It was a wonderful business combined with a bunch of
foolishness that could easily be cut out. And people were coming in
who were temperamentally and intellectually designed so they were
going to cut it out. That is a model you want to look for.
And you may find one or two or three in a long lifetime that are
very good. And you may find 20 or 30 that are good enough to be
quite useful.
Finally, I'd like to once again talk about investment management.
That is a funny business because on a net basis, the whole
investment management business together gives no value added to all
buyers combined. That's the way it has to work.
Of course, that isn't true of plumbing and it isn't true of
medicine .If you're going to make your careers in the investment
management business, you face a very peculiar situation. And most
investment managers handle it with psychological denial just like a
chiropractor. That is the standard method of handling the
limitations of the investment management process. But if you want
to live the best sort of life, I would urge each of you not to use the psychological denial
mode.
I think a select few a small percentage of the investment managers
can deliver value added. But I don't think brilliance alone is
enough to do it. I think that you have to have a little of this
discipline of calling your shots and loading up if you want to
maximize your chances of becoming one who provides above average
real returns for clients over the long pull.
But I'm just talking about investment managers engaged in common
stock picking. I am agnostic elsewhere. I think there may well be
people who are so shrewd about currencies and this, that and the
other thing that they can achieve good long‑term records operating
on a pretty big scale in that way. But that doesn't happen to be
my milieu. I'm talking about stock picking in American
stocks.
I think it's hard to provide a lot of value added to the investment
management client, but it's not impossible.
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