The Berkshire Special 2018

The ever-evolving Mr. Buffett

The Oracle of Omaha’s journey has been one of continuous transformation

Chomp chomp chomp went the two wise men over peanut brittle and Coke. Not exactly what your doctor would approve if you were 87 and your best friend 94. In fact, the Berkshire movie this year even made fun of Charlie Munger, timing him as he struggled with opening a box of See’s peanut brittle. An earlier version of the movie in 2013 featuring a spoof of Breaking Bad had Munger going, ‘Brittle, bitches!’ in homage to Jesse Pinkman. This time around Warren himself was in the act, poking fun at Munger and opening a See’s box in a jiffy, no sooner had they settled down. His antics apart, shareholders love Warren Buffett for the millions he has made them but on the day of the annual meeting, he is more of a teacher than legendary investor. He has always wanted to be one and he is indeed. 

He opened the meeting after joking around with Munger, where he went down memory lane, right to when he bought his first stock — the March 1942 investment in Cities Service, which he bought for $38 and sold for $40, but not before it had dropped all the way to $27. The stock went past $200 soon after, but the point he was trying to make was that $10,000 invested in the index at that time would today have compounded to $51 million. A similar amount invested in gold would have grown to $400,000. And through this Buffett reiterated his belief that America would do well in the future too. “Think about how America will do over your investment lifetime. You’ll do well. Forget about the rest,” he declared. 

This is not the first time Buffett has voiced his optimism over America — he has famously talked about what he calls the “ovarian lottery” — the fact that he was born in America as opposed to any other country in the world, where the chances of success would have been vastly different. But his stupendous climb to becoming an ultra-billionaire is thanks to his metamorphosis of sorts as an investor. 

Looking back at his 53-year Berkshire track record, compounding return at 20.9%, Buffett seems to have lived his entire life by German mathematician Carl Jacobi’s maxim “Invert, always invert.” Introduced to him by none other than the incredibly conscientious Munger, the maxim calls for turning a problem upside down in order to find a solution. Thomas Russo, managing member, Gardner Russo & Gardner, explains, “Invert is about finding a solution working your way backwards and asking the opposite question. Once the answer is clear, you know what not to do.” Sticking to the invert method has ensured avoiding big mistakes at every stage — something that’s incredibly important to stay alive in investing. Interestingly, Buffett’s philosophy of “If something is not worth doing at all, it is not worth doing well” is the flipside of Munger’s “And then what?” which is what really keeps them from doing stuff not worth pursuing, adds Russo.

Looked at another way, applying the invert method to Buffett’s rare less-than-modest assertion that “I always knew I was going to be rich,” he only needed to adhere to Munger’s “Tell me where I’m going to die, so I won’t go there.” That approach has allowed Buffett to sidestep errors and look at different dimensions at every stage in order to tailor the perfect strategy to propel himself towards his goals. 

Well, it is surely not as easy as it sounds. In the stock market, surprises and shocks turn up every minute, day and year. “What has worked in one decade in investing has seldom worked in the next,” emphasises Mohnish Pabrai, founder, Pabrai Investment Funds. “If Buffett and Munger have done so well, it’s because they are learning machines.” 

That’s true. As a young graduate, Buffett was far from the astute communicator he is today. But he understood the importance of communication and took Dale Carnegie lessons to improve his public speaking skills. Now, his marathon Q&A along with Munger at the Berkshire Hathaway Annual Meeting is the stuff of legend. Ted Seides, founder, Hidden Brook Investments and a familiar name to regular attendees of the annual meeting, says, “The transition undergone by Buffett is absolutely fascinating. He worked extremely hard at overcoming his tendency towards introversion, knowing how important that would be in achieving his goals.”

As for investing, at every juncture, Buffett could have done things in many different ways — both what he did and what he did not do, have contributed in equal measure to the final outcome. It can be traced back to the time he was reshaping Berkshire Hathaway itself. As Berkshire was growing, it could have easily adopted the private equity model, but it was Munger’s idea to adopt the current structure, where capital could easily move from one subsidiary to another without paying distribution tax. “Today, Berkshire’s structure is one of its greatest competitive advantages and Munger, the attorney, played a role in fortifying that,” Russo says. 

Starting off with Graham, then moving over to ride on the theme of moats for the longest time, to steering towards buying utilities and technology, sectors he never fancied, to forging a rather unlikely partnership with Jorge Paulo Lemann of 3G Capital at the age of 83, Buffett has done everything he could to take him forward. “He is the most versatile investor I know of. He has such a wide canvas. He buys businesses. He operates them, at least in terms of handling their surplus capital. He buys and sells securities. He does distress investing. He does arbitrage. There is nothing in the field of investing that he doesn’t do and he has done most of those things brilliantly. If that’s not fascinating for a student, what else will be?” says Sanjay Bakshi, professor, MDI and managing partner, ValueQuest Capital.

Cigar butts to brands
It was Munger again, who advised Buffett to make the shift from a quantitative approach to high quality businesses. Having compounded his capital at a crazy pace, Buffett realised that nothing ruins future success like past success. And his ability to profit from buying a 50 cent dollar bill became constrained by the virtue of his success. Having delivered exceptional net return (24.5%) for more than a decade, he could no longer continue on the same trajectory. It was 1969, when he realised there were no more 50 cent dollar bills as the market had pretty much vacuum-cleaned them up. And if they did ever show up again, he knew that the act of buying and closing the discount was taxable. “He did not want to pay taxes. If he could find a business with a competitive economic advantage and a margin of safety, then there was no need to sell the business,” points out Russo. That’s when Buffett made the switch from buying Graham-style cheap stocks to quality businesses that could be held forever. “Moving from buying cigar butts to picking brands was deeply impactful in his ultimate outcome,” says Seides, who conceded the wager against Buffett, which he had initiated when he was with Protégé Partners. The $1-million wager pitted the 10-year performance of the S&P 500 against a selection of five hedge fund-of-funds from 2008 to 2017.

Coming back to Buffett, companies like See’s Candies served as the ideal replacement for the growing pool of capital as they eliminated re-investment risk. “Graham was not scalable. Graham did not care because he was not interested in making a lot of money for himself,” Buffett confessed during the 2018 annual meeting. He also understood that companies with low-capital intensity and pricing power like See’s Candies were the best hedge against inflation, a key concern around the 80s. After See’s, Buffett never went back to ‘cigar butts’ nor did he fish for turnarounds or outright distress. Earlier, too, the rare exceptions that he made for distress were if he found a great franchise that had lost its way. That’s how American Express, Geico and Wells Fargo came in. Even the bets he made during the 2008 crisis such as Goldman Sachs, Bank of America or GE were all stellar businesses available cheap because the market was gripped by fear. Of course, GE again is at an extremely tumultuous point in its history. 

Jeff Gramm, founder, Bandera Partners, says through his investment in American Express after the Salad Oil Swindle in 1964, Buffett learnt the value of a good business that can reinvest its own capital and compound money for shareholders over time. American Express had lent heavily against an inventory of salad oil. It was later found that most of the collateral was water and its stock went down more than 50%. Since the American Express episode, Buffett set out to find more of those. Of Berkshire’s current holdings, American Express, Coca-Cola and Wells Fargo have been in the portfolio for more than 20 years (see: Mostly for keeps). 

Even though he graduated to buying only quality businesses, his learning that it was more prudent to throw in the towel rather than spending good money after bad came from his experience with Berkshire Hathaway. The extent to which the business was changing and losing its competitiveness was only visible after he took control of the ailing textile company. CEO Ken Chace did his best to salvage what he could, ensured a few good years, but it just did not seem worth the effort. That was perhaps Buffett’s first brush in realising the distinction between good and bad businesses and the role of management, which he has famously articulated, “With few exceptions, when a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” That also reinforced the truism that turnarounds are almost impossible, so trying to bet on those may just not be worth the effort. “Both our operating and investment experience cause us to conclude that turnarounds seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price,” Buffett has said. 

Hostile to amiable
The other noticeable difference was him moving away from the activist stance that he had successfully used earlier. That change too, came about because of the realisation that while aggression might be delivering results, the model was not scalable beyond a point. After all, managements surely will not greet an investor with open arms if they knew he was famous for creating trouble. 

Gramm covered Buffett, the activist in much detail in his book Dear Chairman. He says one has to remember that Buffett trained under Benjamin Graham, who occasionally employed activism, proxy fights and controlling positions as part of his value investing style. So when Buffett was working at Graham-Newman, he certainly saw many of these situations unfold, including Graham’s directorship and controlling stake in Philadelphia and Reading Coal & Iron. Back in those days, many public companies traded for significantly less than their asset value — and sometimes even their balance of excess cash — and investors sometimes had to push companies and their board of directors to share the wealth with shareholders. “During Buffett’s early investing days, he was an active and engaged investor. Many of his early cigar-butt type investments in Buffett Partnerships (started in 1956) likely involved engaging management teams and pressuring them to regard their shareholders,” says Gramm. But the most famous early activism case for Buffett was Sanborn Maps. It owned an investment portfolio that was worth well in excess of the trading value of the stock. Buffett bought a 30% stake in the company and joined the board of directors. In the end, the rest of the board capitulated to Buffett’s demands. The company ended up using its investment portfolio to tender for outstanding Sanborn shares.

As Gramm mentions, Buffett’s involvement in Dempster Mill, another famous early investment, really turned him away from hostile shareholder activism. Dempster was a declining windmill parts company in tiny Beatrice, Nebraska. It traded for significantly less than its asset value and its business was clearly worth more dead than alive. Through Munger, Buffett found an able CEO in Harry Bottle to turn Dempster’s tired assets into ready cash, which he then invested in stocks. “Buffett generated a huge amount of money for Dempster shareholders, but he was vilified in the local Beatrice press for being a profit-hungry corporate raider. The negative coverage really bothered him, and he did not want to go through anything like that again,” says Gramm. 

Then on, there have in fact been instances of Buffett supporting managements against activist investors. During the American Express scandal in 1964, Buffett famously sided with the management against activist investors, who wanted the company to ignore claimants defrauded in the swindle, says Gramm. “Buffett knew that treating these claimants — many of whom were big financial institutions — poorly would do long-term damage to the American Express brand that was not worth the near-term savings.”

Then again in early 2014, Buffett refrained from voting against the executive compensation for Coca-Cola after calling it excessive, joining other voices of dissent. That puzzled investors. It was evident that Buffett didn’t want to go to war with the management, but nudge them anyway for a better outcome. Had he expressed dissent directly, he might have aggravated the situation and probably affected the value of his holding. Says Russo, “At IBM he had a smaller position, so when he saw that the management was significantly wrong, he could just pack up and leave. But Coke was a much bigger position, a long-standing one. Possibly, since he’s worshipped Coke for so long, he didn’t take a critical view of what looked like an unmeasured wealth transfer to management.” In October that year, Coca-Cola did announce a revision in the compensation structure. Buffett has never got into conflict since he turned amiable and his recent decision to vote against the board at USG Corp is a rare instance of him upbraiding incumbent management.

Buffett, being a diehard capitalist, has never advocated diluting shareholder equity. Neither has he believed in giving away stock options, opting for cash bonuses instead. “Warren has always perceived his stock to be relatively undervalued. So he never wanted to give a dollar away for 60 cents. At the same time, he did not want to deliver over-valued certificates. Having the cash, they could buy it if they chose to,” says Russo. 

Like Munger, Buffett was quick to understand the power of incentives and his strength has been to craft the best incentive compensation for the people he oversees. For instance, the reward mechanism for See’s Candies is based on maintaining growth and a high profit margin rather than on re-investment. In fact, Buffett and Munger haven’t re-invested anything since they bought See’s, still it has managed to spin off $2 billion. On the contrary, in the case of Nebraska Furniture Mart, the reward mechanism is probably on more roll-outs as it has expanded to other states, Russo elucidates, “That ability to set the terms of compensation, which then drives behaviour is truly unique and helps in aligning objectives and creates long-term value.” 

That congruence of interest and a trust-based working style is also the reason Berkshire has never lost a CEO to its competitors. Berkshire CEOs tend to be lifers, the only recent exception being David Sokol over allegations of insider trading in Lubrizol. After a two-year investigation, the SEC did not pursue insider trading charges against Sokol. “For the managers, there is a sense of participation in a noble journey. They also make a lot of cash and get to play the game as it should be without the pressure of quarterly earnings. If they go anywhere else, they will have to play the quarterly game and people with an ethical bent hate it, as they have to do something just to make earnings look better,” explains Russo. 

As simplistic as it may sound, there is practically no big company that seems to have imbibed these best practices — neither in terms of decentralisation, nor in terms of compensation. Pabrai says, “Every company has a DNA and the culture of a company is the most difficult thing to change. It is not something that you can transplant; it has to be in the company right from the beginning.” Unfortunately, in corporate America, as also in the rest of the world, it is Wall Street that determines how companies are run. Therefore, the incentives, too, are aligned accordingly than to maximise long-term return. 

Again, it’s not just about managers. What Munger calls the “seamless web of deserved trust” has actually become a competitive advantage for Berkshire. It’s because of this deserved trust that private companies are happy to look at Berkshire as their preferred permanent home. That culture is something that Buffett has assiduously cultivated over decades and one that marked an important turning point in his investment style. So far, Buffett has bought about 60 high quality private companies, none of them via confrontation
or activism. 

Sizing up
If deserved trust has become Berkshire’s moat over the years, Buffett has also been astute in tailoring investments to meet the demand posed by the ever-growing pool of funds. After buying several private companies in the late 1990s and 2000s, Buffett made a $7-billion bet on junk bonds, followed by a $20-billion bet against the dollar in 2003 and 2004, before making his first international acquisition: the $5-billion purchase of Israeli cutting tools company Iscar, notes William Thorndike in The Outsiders. Says Bakshi, “The capital available to Buffett has grown so much that he can’t do too much of the esoteric things he used to do when he was much younger with much less capital. He has thus, moved into situations that can absorb a lot of capital.” Berkshire has about $20 billion-$25 billion of new capital coming in every year. It is not easy to put it to work. Buffett has been opportunistic as well as willing to expand his horizon, transitioning from buying convertibles in his partnership days, to buying consumer franchises as a mainstay, to finding incredible businesses that can absorb a large pool of capital. Pabrai adds, “Obviously, he would prefer that it goes to work at Google and Amazon, which don’t need capital but either they are expensive and/or outside the circle of competence. That is why he put it to work into companies like Burlington Northern and Precision Castparts, where the multiples were not egregious.” 

While Precision Castparts had a strong moat given its preferred supplier relationship with Boeing and Airbus, it is also about the belief that we are entering a virtuous cycle with airplane engines. “There will be more demand as more miles are being flown. It is a quasi bet on more business for aircraft manufacturers. The Chinese will have 150 million tourists flying...,”says Russo.  

Burlington Northern, on the other hand, was a bet on traffic moving to railroads and his timing couldn’t have been better. Burlington is not an exception. Buffett has explored every sector that can not only absorb sizeable capital but also offer a guaranteed return. Russo says that is the genesis behind the investments at Berkshire Hathaway Energy. “It can consume $6 billion to $10 billion of capital spending at low regulated double-digit return. If you can re-deploy billions of dollars per year for the next decade at a guaranteed rate, it eliminates re-investment risk and can be a compounding machine,” he explains.

But then such super-sized opportunities that can deliver excess return are rare. That’s why Buffett now seems to be hunting for opportunities for substantial productivity gains, and global growth to generate excess return. That also explains the tie-up with 3G Capital. 

Mega-bet partner
The partnership between Buffett and Lemann is not the least bit unlikely because Buffett is gregarious when the situation demands and Lemann shuns public appearances. Through his career, Buffett has only forged two deep partnerships — with Munger whom he has known for 59 years, and with Bill Gates who’s been a friend for 27 years. While Buffett did know Lemann since 1998 by virtue of being on the board of Gillette, he joined hands with Lemann only four years ago when he was 83, and Lemann was 74. That partnership stems out of a virtue for which 3G is loved by Buffett but hated by naysayers — cutting costs and bringing efficiencies really quickly to generate return.   

It’s horse sense, really. “The 3G partnership keeps Buffett away from the super aggressive cost cutting measures that 3G is so famous for. And he can still participate in the upside from those cost-cutting measures,” says Bakshi. Despite apprehensions over seemingly different cultures of Berkshire Hathaway and 3G Capital, Pabrai says it’s perfectly consistent with Buffett’s approach. “Buffett’s style is to identify a manager and leave him alone. What would be a violation of the Berkshire model is not giving the manager the leeway to run things the way he wants to,” points out Pabrai.

It’s not all been smooth sailing though. 3G’s offer for Unilever was rejected by the target and its effort to pull in growth at Kraft Heinz hasn’t yielded desired results so far. Buffett also stepped down from the board of Kraft Heinz fuelling speculation that he wasn’t happy about how the integration was progressing. Pabrai says all this idle chatter reminds him of the opening lines of a poignant Hindi song, ‘Kuch toh log kahenge, logon ka kaam hai kehna. Chhodo bekaar ki baaton main kahin beet na jayein raina’, which roughly translates to, ‘It is in people nature’s to comment, why should we lose sleep over it?’ Buffett no longer being on the Kraft Heinz board has nothing to do with his pleasure or displeasure with 3G. For a while now he has been cutting down on his travel and other board commitments except Berkshire,” he adds.

Pabrai’s assurance notwithstanding the partnership with 3G has attracted its fair share of criticism for its brutal cost-cutting at Kraft Heinz. Probably more than he might have got during his early activist days. Russo says one aspect of 3G’s Kraft Heinz investment that has caught up with them is that it does not really have a robust global footprint and it is finding it hard to drive growth in the mature US market. “That is the exact opposite of AB InBev, where they have substantial emerging market presence. The way out for Kraft Heinz probably involves them doing something globally and hence, the acquisition offer for Unilever.” He thinks even as the 3G management works on fixing Kraft Heinz, Buffett has a bigger challenge at hand, which is ensuring that the events at Kraft Heinz do not somehow poison the sensibility that Berkshire is still the best home for private businesses. “The risk to Berkshire is that one of the owners of the largest private businesses in North America reads about the dismemberment of the long-standing operations within the combine of Kraft Heinz and worries that Berkshire may have changed its stripes from the supportive, protective and permanent home that it was for private companies sold to it directly,” says Russo.

Indeed, that’s true, but then, it comes back to the same thing: Buffett’s style is all about shaping a strategy to suit the times. He chooses not to be dogmatic and is willing to change his opinion if the facts or circumstances change, even if it goes against his strongly-held beliefs, assertions or apprehensions.

Changing stance
Airlines and technology are excellent examples of Buffett’s open mind. He revisited both businesses, overcoming his past bias, when he figured out that the contours of the business had undergone a change. Munger has always stressed on learning to maintain objectivity, especially when it’s hardest. Despite a profitable stint in USAir earlier, Buffett had always played down the economics of the airline business. That is why most investors were caught by surprise when airlines popped up in the Berkshire portfolio. Chetan Parikh, co-promoter, Jasmine India Fund, says, “Buffett and Munger change their mind when the facts change. The mark of a superior investor is his ability to battle commitment bias. It is hard to somersault when you have said something vehemently in public.”

In a post-consolidation era and the current regulatory environment, airlines have gained pricing power and the budget model has gone mainstream with each service being charged separately. Though Buffett has now said, “I wouldn’t rule out buying an entire airline,” Guy Spier, founder, Aquamarine Capital, says the airline investment was probably not Buffett’s decision, but that of his investment managers. “Airlines was probably the handiwork of Ted Weschler and/or Todd Combs,” he says. Spier’s speculation stems from the fact that before Weschler was handpicked by Buffett, he used to run his own investment company, Peninsula, which had a history of investing in airlines. He was one of the major investors in the America West and US Airways merger. US Airways then merged with American Airlines in 2013. If one looks at Berkshire’s holding in airlines, it does seem like an industry bet with the highest holding in United and American respectively, where Doug Parker is CEO. Parker was the CEO of the US Airways-America West combine and it probably only highlights Weschler’s comfort level and confidence in Parker. Even if buying airlines was Ted or Todd’s call, for Buffett to overcome his long-standing stance on airlines given the changed economics only demonstrates his openness. 

It’s exactly the same with technology. After steering clear of dotcoms in the face of severe criticism before the boom went bust in 2000, Buffett gradually tested waters with IBM. And then, Apple followed much later. The IBM play did not work out as planned but Apple, despite being a cutting-edge technology company, has captured Buffett’s imagination. “He has not gone into a pure technology business like semiconductors but more into consumer platforms with network effects, where the only risk is regulatory. It is an appreciation that the brand and distribution moats here are different than in traditional consumer businesses,” says Parikh. Apple’s moat is its captive customers, who are locked in because of its high-switching costs. Besides, Russo adds, “It was fuelled by technology but driven by consumer need, emotional and brand oriented.”

That’s Buffett’s genius: figuring out that despite being a technology company, there was an element of predictability that had emerged in Apple’s earnings, which made it a credible investment when he bought it in early 2016. “Buffett’s picked low-risk bets in high-risk sectors,” says Russo. Simple as it may sound, distilling investments this way calls for sharp insight into not just consumer behaviour and the technology landscape, but also how they weigh on balance. The next couple of years would be very interesting as Apple is now the biggest holding by value in the Berkshire portfolio.

Clearly, while Buffett has constantly propagated staying within one’s circle of competence, he himself has been continuously widening his own circle of competence. Now, having taken a bold call on technology, not to mention airlines, Buffett has kicked off on an entirely new innings at the age of 87. So, could Amazon be next? Both Buffett and Munger have spoken highly of Jeff Bezos but so far Berkshire has not invested in Amazon. Russo says for the longest time Buffett and Munger mistakenly categorised Amazon as a technology business instead of one offering consumer services. “Now, having realised that, it is extremely difficult for the world’s most rational value investor to step up to the plate at the current valuation. If the price goes down temporarily and is not life threatening, I think it is a business that Berkshire would want to own,” says Russo. “But he will have to compete with me as I would want to buy at the same time!” he chuckles.

The evolution
Having a stupendous track record investing from the age of 11, no one competes with Buffett for miles, barring himself. As much as Buffett today comes across as a genial grandpa, he wasn’t as genial to begin with. He is the same man who made a big deal about a buyback where he was shortchanged 12.5 cents a share, but doesn’t bat an eyelid now while giving billions away. Were it not for his “childish behaviour” (as mentioned in the 2015 annual letter) when he refused to tender Berkshire Hathaway stock because the offer price was below the agreed price, the world would have never seen an investment legend.

And to create this legendary track record, Buffett has changed tack not once, but several times — the goal was always to win, but the framework needed to win couldn’t ever be static. Berkshire Hathaway started off with $3.8 million whereas the investable surplus today is $120 billion and growing. While the corpus scaled relentlessly over five decades, the investment landscape has changed with some businesses dead and gone, several others having turned from good to bad, or bad to good, and of course, birth of new businesses with promising potential. What has helped Buffett and Munger during their journey is their indefatigable ability to learn, which has enabled them to find the next frontiers while also expanding their circle of competence. “Warren is like a kid in a candy store — his child-like curiosity for the world remains undiminished,” says Spier. That explains his evolution as an investor too.

For all the dynamism Buffett has displayed, Parikh reminds us of all the things that have not changed that have contributed equally to the success. A thorough understanding of the business with all its moving parts, and buying only with a margin of safety continue to be Buffett’s central piece in investing. Parikh adds, “More than the billions they have made, it is about how they have made it. Old school value systems of integrity, fair play, associating with high quality people have not changed.” 

Add to that Buffett’s food habits — his diet consists of hamburgers, ice cream, steak and Coke (switched from Pepsi after the launch of Cherry Coke), more or less what he used to have as a six-year-old. It works for him. Surely, it takes the complexity out of one key decision: what to eat. Willpower leaks everywhere, even when you resist stuff that you want to eat. Buffett reserves his willpower for where it matters most: staying rational.