Good Reading -- May 2015
Sorry for all the Buffett material, some of which may be old hat by now -- but the 50th anniversary is a special occasion. Hope everyone is doing well.
"Dealing with China: An Insider Unmasks the New Economic Superpower" -- Hank Paulson's new book is really good. Anyone interested in China should read it even though not everyone will agree with his perspective.
On the same topic, this month's issue of Foreign Affairs is all about China. There are a lot of articles that tie to Paulson's book: "China's Dangerous Debt" and "China Will Get Rich Before It Grows Old: Beijing's Demographic Problems are Overrated" and "Embracing China's 'New Normal': Why the Economy is Still on Track." (Registration required for two free articles; subscription required for full access.)
"Rent-a-Foreigner" -- ($) This short article and documentary looks at how Chinese housing developers are hiring foreigners to stand around and lend an air of excitement to their properties. The video is especially absurd.
"Berkshire Hathaway Inc.: Celebrating 50 Years of a Profitable Partnership" -- This book was produced and published by the company, and it has some fascinating historical tidbits that I've never seen anywhere else. These copies on eBay were linked from the company's website.
Warren Buffett and Charlie Munger: billion-dollar partnership -- Along the same lines, this Steve Jordon article in the OWH didn't seem to get much attention but it's really good -- several things in here I hadn't read before.
"Red Notice" -- This book by Bill Browder, manager of Hermitage Capital, is his autobiographical tale of "high finance, murder, and one man's quest for justice." Browder was the largest foreign investor in Russia before the government turned on him with prosecutions, beatings and the imprisonment, torture and murder of his lawyer, Sergei Magnitsky. Magnitsky's death was truly awful, and Browder has made it his life's work to fight the Russian government in avenging Magnitsky's death. Browder is a good writer and this book is engrossing even without the fascinating (if tragic) real-life implications. A huge thanks to RJ for recommending this to me in Omaha.
The Knowledge Project -- Shane Parrish has a new podcast, and it is as good as you'd imagine given Farnam Street's exceptionally high-quality material. The first edition featured Michael Mauboussin.
"When Your Kid Moves Out West, She Takes the U.S. Economy With Her" -- A look at American demographics with some interesting numbers and charts.
Warren Buffett, taken from a CNBC interview in Omaha on May 4, 2015 (errors and emphasis are my own):
“Very occasionally over a 60-year period it’s been very clear that the market’s really overvalued or dramatically undervalued. Most of the time I don’t have the faintest idea of whether it’s on the high side or the low side. When you get the extremes…1973 and ’74 was the cheapest market I’ve ever seen including our recent panic, but our recent panic was such that you could clearly say that stocks were undervalued. Back around 1999 and 2000 I said they really were overvalued. What you can say now -- [it’s] not very helpful – but the market against normal interest rates is on the high side of valuation. Not dangerously high but on the high side of valuation. On the other hand, if these interest rates were to continue for 10 years stocks would beextremely cheap now. The one thing you can say is that stocks are cheaper than bonds, very definitely." [see below for the rest of the commentary in full context]
"Forget Buffett the investor. Follow Buffett the manager." -- There is a lot of truth in this Roger Lowenstein article.
Larry Cunningham had a take on this subject in the New York Times and the Omaha World-Herald and in an academic paper.
"Kahneman: Clients Driven by Losses, not Gains" -- This article is from a speech in February that I missed, but as always Kahneman's thoughts are worth the time.
Continuation of Buffett commentary on CNBC from May 4, 2015
Forget Buffett the investor. Follow Buffett the manager
APRIL 21, 2015, 10:00 AM EDT
Warren Buffett boasts a 50-year record of success as a CEO. So why hasn’t corporate America done more to imitate his management style? Blame executive-suite timidity … and Wall Street.
Warren Buffett is regarded as the best investor of our time; arguably, his management record is just as singular. He took over as head of Berkshire Hathaway in May 1965 — 50 years ago. And he is still at it. Think about that. Alfred P. Sloan, perhaps the most storied CEO in American business, ran General Motors for 23 years. John D. Rockefeller ran Standard Oil for 27. In recent times, Bill Gates was CEO of Microsoft for 25.
But here’s the thing. Investors around the world avidly mimic Buffett’s investment approach, yet it’s fair to say his managerial model has had zero impact on the corporate culture. Charlie Munger, Buffett’s longtime partner and Berkshire’s vice chairman, says the “Berkshire system” is essential to its success. Nonetheless, Munger wrote in this year’s annual shareholders letter, “No other large corporation I know of has half of such elements in place.”
One hallmark of Buffett’s management is unusual attention to capital allocation (for Buffett, adding a company to Berkshire is akin to adding a stock to an investment portfolio). But once he makes an acquisition, he almost never sells, and gives managers extreme autonomy. Another is shunning of bureaucracy. Berkshire has no processes to standardize the more than 60 operating units it owns, no companywide budgeting for a conglomerate with 340,000 employees. A third hallmark is renunciation of familiar rituals that in Buffett’s view promote short-term thinking. Thus, no earnings guidance, no regular stock splits, no stock options.
Admittedly, not every aspect of Buffett’s style would fit every business, and you can argue that elements of his approach can lead to problems. (More on that later.) But over the half-century of his management, Berkshire’s stock is up 12,000 times, while the Dow Jones industrial average is up 18 times. Berkshire’s market cap is $350 billion, the third highest in America. You’d think some manager would find something worth imitating.
(A disclosure: I’m invested in Berkshire, I sit on the board of a mutual fund that owns the stock, and I’m the author of a Buffett biography. So don’t look here for a disinterested forecast of Berkshire’s future.)
Oddly enough, Buffett’s signature tactic—friendly acquisitions of strong, well-led companies—was violated when he bought Berkshire itself. As Buffett tells it in his most recent shareholders letter, his takeover of Berkshire, a textile manufacturer besieged by low-cost rivals, came about almost impulsively. After his investment partnership bought a stake, Buffett grew disenchanted with the company’s management strategy. He eventually bought a controlling interest and ousted the CEO. That was in 1965, when Buffett was all of 34 (he is 84 today).
Buffett’s first lesson came from observing the former CEO’s errors—don’t put good money into a bad business, even if it’s the business you are in. Berkshire struggled in textiles for 20 more years; all along, Buffett deployed its meager profits into greener pastures. By the time he closed the mill in 1985, Berkshire owned major interests in insurance, newspapers, candy, and manufacturing, along with a large portfolio of common stocks.
By then, Buffett’s investment partnership had liquidated: Its investors received stakes in Berkshire, and Buffett became the largest individual owner. The partnership legacy is important because the company is still run like a partnership. Berkshire’s directors get only token compensation; they don’t get liability insurance either. And they have purchased large amounts of stock. This arrangement—almost unheard of in corporate America—means the directors must truly believe in their mission.
The partnership ethos is also visible in Buffett’s relations with stockholders. Buffett does not do things to buoy the stock in the short term (such as issue earnings guidance), because he seeks to encourage long-term ownership. He rarely uses shares to pay for acquisitions, because he does not want to dilute the stock.
Buffett also shuns stock options because they could unhitch the interests of executives from those of ordinary investors. Indeed, in executive pay, Berkshire staggeringly departs from convention. Buffett and Munger collect salaries of $100,000 each; neither receives a bonus. (Many CEOs haul in $100,000 every day or so.)
If greed dissuades rivals from adopting Buffett’s pay model, something else—call it managerial insecurity—inhibits them from replicating his indifference to short-term results. Many CEOs live in mortal fear of disappointing Wall Street, and often settle for the appearance of value as distinct from the substance. Stock splits to increase liquidity are a sign of this mentality, as are spin-offs of corporate assets to “unlock” value.
Lawrence Cunningham, a professor at GeorgeWashington University and the author of Berkshire Beyond Buffett, says Buffett learned much of his management style from Tom Murphy, the retired Capital Cities/ABC CEO. (Buffett was a big Cap Cities investor, and Murphy now sits on Berkshire’s board.) But Cunningham notes that public companies that try to imitate Buffett face obvious hurdles. Witness GM, where short-term shareholders recently demanded that the company distribute billions in cash (even though GM is only a few years removed from bankruptcy). Anxious to avoid a proxy battle, managers caved; Buffett’s controlling position, like that of a private operator, insulates him from such pressures.
Still, Berkshire is public, and its style violates some governance norms. As Buffett recently wrote, “We trust our managers to run their operations.” That honor system slipped in 2011, when David Sokol, head of Berkshire’s energy business, was revealed to have invested $10 million in a company and then recommended that Berkshire acquire it. While that affair tarnished Berkshire, Cunningham depicts it as the downside of a worthwhile tradeoff. If Berkshire beefed up its governance bureaucracy, he says, “it would slow decisions, you would miss opportunities, and there is no guarantee you would not have problems.”
Is it possible that Berkshire works—and this is the question that causes agony for shareholders—only because Buffett runs it? Arguably, had a rules-bound, less cozy board (one stuffed with fewer of Buffett’s associates, friends, and family) sent Buffett to pasture at, say, age 65, its shareholders would now be poorer. “How many people do you think could do what Warren does?” Munger asks rhetorically.
Yet letting other companies off the hook because Buffett is special seems too pat. His and Munger’s basic complaint—that corporate America is too bureaucratic and too obsessed with the short term—is absolutely correct. Munger, in his letter, argues that “versions of the Berkshire system should be tried more often elsewhere, and the worst attributes of bureaucracy should much more often be treated like the cancers they so much resemble.” It is hard to think of another company where the vice chairman would violate protocol by lecturing his peers and employing such an insensitive metaphor. Other executives should try it.
How to run your company the way Buffett does
Three management takeaways from Warren Buffett’s 50 years at Berkshire Hathaway
1. Leave your managers alone — Managers at the 60-plus business units owned by Berkshire have a lot of autonomy, and that encourages them to stick around.
2. Bureaucracy must die — Extra layers of corporate decision-makers in budgeting, legal affairs, and public relations mean you’ll miss opportunities.
3. Don’t massage the stock price — Earnings guidance, stock splits, and spin-offs are short-term moves that do little or nothing for your shareholders in the long run.
Roger Lowenstein is the author of America’s Bank: The Epic Struggle to Create the Federal Reserve (to be published in October 2015).
This story is from the May 1, 2015 issue of Fortune magazine.
Kahneman: Clients Driven by Losses, Not Gains
Further advice from the father of behavioral finance on the perils of hindsight, the power of client regret and what really sets apart Warren Buffett
In an address that was part social science, part high-end psychology and part homespun advice, with lessons from the “idiotic call” at the end of Super Bowl XLIX, Daniel Kahneman gave behavioral finance advice directly to advisors on Tuesday on day two of the IMCA New York Consultants Conference.
Kahneman, a psychologist who won the Nobel Prize in economics and recently published "Thinking Fast and Slow," began by speaking about loss aversion: that human beings feel and fear loss much more than they enjoy gain.
Saying that “your grandmother knew it and so did mine,” the Princeton professor said “your clients are more sensitive to loss than gain,” that they can be “infinitely loss averse when ruin” is one of the possible outcomes and that when it comes to wealth preservation, “people aren’t concerned about their level of wealth, but about changes in their wealth.”
To illustrate a related loss aversion principle known as the endowment effect, Kahneman related the findings of a famous experiment he and behavioral economist Richard Thaler conducted with coffee mugs and two groups of people. One group was given mugs and the others were given a sum of money: the mug owners, it turned out, demanded an average of $7 to sell their recently acquired mugs to the moneyed group; but the mug-less group was only willing to pay an average of $3 to buy the same mug.
As Thaler defined it, the endowment effect found that “people often demand much more to give up an object than they would be willing to pay to acquire it.” When working with clients on investing, Kahneman suggested that advisors recall this effect, that “people don’t like giving up things” even when they’ve only owned those things for a short time, like stocks in a portfolio.
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He then turned to the concept of hindsight, in which “an event seems predictable after the fact.”
His example came from Super Bowl XLIX. “Look at the amount of credit the Patriots got after that stupid play” in which the Seahawks attempted a goal-line pass that was intercepted. “If the Seahawks had won, everything would have been different,” with commentators praising the Seahawk players. As it was, however, “everyone should have known, after the fact, that the Patriots were the stronger team.”
Much of life comes down to luck, Kahnemann preached: While the Patriots had “no control over the Seahawks’ idiotic call,” the winning Patriots after the fact felt they deserved to win. Since “the world is not predictable, a lot of what happens is luck. We greatly underestimate the role of luck; we overestimate the management” of good firms.
“Hindsight induces us to believe we understand the world because we understand the past,” which is a particularly dangerous belief for advisors to exhibit.
“Advisors will get blamed for not knowing what will happen” by their clients, he said, despite the fact that the future is unknowable.
While many observers claimed they saw the financial crisis coming, there’s a big difference between “thinking” and “knowing an event will happen. All too often, he said, the people who predict events, especially in the markets, are writing in “invisible ink”; only later will they say such predictions are “written on the wall” for all to see.
Returning to how clients feel, Kahneman warned of the “emotion of regret,” saying that clients will “feel the pain acutely” of lost investment opportunities and then will, regrettably, seek to act on that regret. He suggested that’s why so many investors, having seen an investment rise in value, will seek to buy that investment after it’s had its run. It’s also why, as research has shown, that mutual fund investors will rarely profit from the increase in a fund’s value, since the investors will far too often buy into and get out of funds, to their detriment.
“Try to prevent people from acting out of regret,” he counseled advisors, and look at the discussion of regret with clients as a “form of vaccination.” In fact, he suggested that advisors should build different portfolios for clients prone to tregret, because they are more prone to “changing their mind at the wrong time.”
Citing the findings of his former student Terrance Odean, now at the University of California, Berkeley, Kahneman said that advisors should realize that “having fewer ideas” about opportunities in stocks “is better” because of the "disposition effect," which shows that clients tend to sell their winning investments and hold onto their losers.
Addressing the issue of overconfidence, Kahneman told advisors not to “trust your own confidence” and to remember that “you cannot predict the future.” Instead, “be confident in the principles and processes you use to work with people, not in what stocks, bonds or the markets will do.”
“If you think you’re an expert on picking stocks, then you should be fabulously rich. If you’re not, you’re probably not” a very good stock picker. However, advisors are “experts on many aspects of financial decision-making.“
He acknowledged that advisor face a particular challenge: “your clients want you to be overconfident.”
He then noted that women in general are less likely to fall prey to the overconfidence effect. “Women are better at figuring out the emotional state of clients," he said. "Men should emulate them.”
Kahneman then presented four suggestions for advisors working with clients.
1) “Get clients to think large,” rather than to focus on the specifics of a portfolio.
2) Encourage long-term thinking among clients, and get them to commit to that approach.
3) Avoid the disposition effect (the tendency to sell winners and hold on to losers) and overconfidence
4) Ask yourself why you should know more than the market. After all, he said, very few active managers beat the indexes, and ‘the market’ is actually the value that all the market participants provide for a given investment.
In response to a question about Warren Buffett and whether his sterling investments are a result of luck or skill, Kahneman pointed out that Buffett is “not in the business of stock picking; he picks companies and managers” that he knows well.
Moreover, Buffett can rely on one effect that the rest of investors can’t: because of his reputation as a great investor, “when he buys a company, the markets” tend to nearly immediately “make the investment more valuable.”
Warren Buffett on CNBC, May 4, 2015:
“Very occasionally over a 60-year period it’s been very clear that the market’s really overvalued or dramatically undervalued. Most of the time I don’t have the faintest idea of whether it’s on the high side or the low side. When you get the extremes…1973 and ’74 was the cheapest market I’ve ever seen including our recent panic, but our recent panic was such that you could clearly say that stocks were undervalued. Back around 1999 and 2000 I said they really were overvalued. What you can say now -- [it’s] not very helpful – but the market against normal interest rates is on the high side of valuation. Not dangerously high but on the high side of valuation. On the other hand, if these interest rates were to continue for 10 years stocks would be extremely cheap now. The one thing you can say is that stocks are cheaper than bonds, very definitely. We’ve seen low interest rates now for six years or so, rates that we really wouldn’t have thought possible, particularly in Europe where they’ve gone negative. And that’s continued a long time, and of course we saw them continue for decades in Japan.
“We own stocks, we’re happy owning stocks, we look at stocks as parts of businesses, we don’t try to guess which way the market –- we have no idea what the market’s going to do next year. Charlie and I never talk about it. [But] if these low interest rates prevail for five or ten years, you’ll look back and say stocks were very cheap. If interest rates normalize you’ll look back and say they weren’t so cheap.
“[Interest rates] have fooled me so far. So I’ve been wrong. I would’ve thought by now that you’d have seen much higher rates than we have now, which are essentially nothing. They’re certainly going to stay low so long as Europe keeps following the present policies, and Europe will probably keep following those policies until they see the European economy come back fairly strong. I don’t know the answer to that. I don’t bet on it. [But] if I had an easy way and a non-risk way of shorting a whole lot of 20- and 30-year bonds, I would do it. But that’s not my game. And it can’t be done in the kind of quantity that would make sense for us. But I think bonds are very overvalued, I’ll put it that way. [And] the central bank has the capacity to keep them in that situation almost indefinitely, so we’ll see what happens on that.
“[The expectation is that rates will start to go up this year or next] but I think it’s difficult, not impossible -- the Fed can do what the Fed wants to do -- but if you have negative rates in Europe, I think there are a lot of consequences to raising rates significantly here. The important thing to remember in economics – people forget it – is you can never just do one thing. It’s like physics. You cannot just change one variable and not have anything else change in the world. When Poland borrows at negative interest rates it has an effect on what we can do without changing export prices, all kinds of things.
“I’m sitting with a lot of money in euros that has to be in euros at our insurance company in Germany. I’m getting a minus rate on that. Well, that gets your attention. If you were sitting with some money in your billfold and every day a little bit of it got clipped away, you’d start wondering, ‘Why is this in my billfold?’ So it pushes behavior. Interest rates push behavior incredibly. And, we are not immune from what goes on in a market as big as the euro market. And I think it’s difficult for us to raise interest rates significantly, certainly. I cannot envision us, for example, having a 4% or something rate here with negative rates in Europe. Now, the gradations you can argue as to how much effect they might have. But this is a very unusual situation and I don’t know how it plays out.”