Chris Lau - Seeking Alpha

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Sunday, February 28, 2010

How to generate a 801,516% Return (Berkshire Hathaway Annual Letter)

Warren Buffett published his annual letter to the shareholders of Berkshire Hathaway. Over a 45 year period, Buffett and Munger produced a total return of 801,516%. This is double that of the return of the S&P 500 in the same period, and represents a 20% compounded annual return.

Here is the link for the full letter.  

One can try to analyze and replicate Buffett's success, correctly or incorrectly. Buffett, however, attributes his success on what he does not do. It can best be summarized with a quote from Munger:

“All I want to know is where I’m going to die, so I’ll never go there.” 
Thinking in mathematical terms, to solve difficult problems:

“Invert, always invert"
Finally, in terms of music:

Sing a country song in reverse, and you will quickly recover your car, house and wife.
Berkshire Activity - A summary

Recall that in September 2008, when the financial markets seized, Berkshire had sufficient cash to inject in the market. In 2009, Berkshire bought a railway company (which is discussed on pages 3-4).

In 2009, Buffett stated in his letter that "the economy ...will be in shambles throughout 2009." His letter also contained 12,830 words which the media did not cover. While Buffett stated his disappointment in the way media covered stories, Buffett did explain that not all of Berkshire's business is doing well. That is, GEICO's entrance in the credit card market proved to be a losing business.

Berkshire also owns NetJets. While the company had its share of success, it has so far costed the company 157M in pre-tax loss, and debt soared from $102 Million (at the time of purchase) to $1.9B in April 2009. Buffett notes that its fortunes are beginning to turn around (debt reduced to $1.4B and earnings are profitable, after losing $711M in 2009).

On a more positive note, Buffett believes the housing problem is largely over (page 11).

Summary of Holdings for 2009:

Shares Company
Percentage of
Owned Cost * Market
(in millions)

151,610,700 American Express Company ........................ 12.7 $ 1,287 $ 6,143
225,000,000 BYD Company, Ltd. .............................. 9.9 232 1,986
200,000,000 The Coca-Cola Company .......................... 8.6 1,299 11,400
37,711,330 ConocoPhillips .................................. 2.5 2,741 1,926
28,530,467 Johnson & Johnson ............................... 1.0 1,724 1,838
130,272,500 Kraft Foods Inc. ................................. 8.8 4,330 3,541
3,947,554 POSCO ........................................ 5.2 768 2,092
83,128,411 The Procter & Gamble Company .................... 2.9 533 5,040
25,108,967 Sanofi-Aventis .................................. 1.9 2,027 1,979
234,247,373 Tesco plc ....................................... 3.0 1,367 1,620
76,633,426 U.S. Bancorp .................................... 4.0 2,371 1,725
39,037,142 Wal-Mart Stores, Inc. ............................. 1.0 1,893 2,087
334,235,585 Wells Fargo & Company .......................... 6.5 7,394 9,021
Others ......................................... 6,680 8,636
Total Common Stocks Carried at Market .............. $34,646 $59,034

Media reported that Berkshire sold positions in  ConocoPhillips, Moody’s, Procter & Gamble and Johnson & Johnson. The reason this was done was to raise cash to buy Dow and Swiss Re. In 2009, Berkshire was bullish on corporate and municipal bonds, a viewpoint that later proved to be correct when these issues rallied.

A Story

The story worth quoting from the letter is in regards to mergers and acquisitions, a theme that may play out this year as credits loosen, the appetite for risks increase, and as Berkshire itself considers other purchasing options:

The seller of the smaller bank – no fool – then delivered one final demand in his negotiations. “After
the merger,” he in effect said, perhaps using words that were phrased more diplomatically than these, “I’m going to be a large shareholder of your bank, and it will represent a huge portion of my net worth. You have to promise me, therefore, that you’ll never again do a deal this dumb.”We owned stock in a large well-run bank that for decades had been statutorily prevented from acquisitions. Eventually, the law was changed and our bank immediately began looking for possible purchases. Its managers – fine people and able bankers – not unexpectedly began to behave like teenage boys who had just discovered girls.
They soon focused on a much smaller bank, also well-run and having similar financial characteristics in such areas as return on equity, interest margin, loan quality, etc. Our bank sold at a modest price (that’s why we had bought into it), hovering near book value and possessing a very low price/earnings ratio. Alongside, though, the small-bank owner was being wooed by other large banks in the state and was holding out for a price close to three times book value. Moreover, he wanted stock, not cash.
Naturally, our fellows caved in and agreed to this value-destroying deal. “We need to show that we are in the hunt. Besides, it’s only a small deal,” they said, as if only major harm to shareholders would have been a legitimate reason for holding back. Charlie’s reaction at the time: “Are we supposed to applaud because the dog that fouls our lawn is a Chihuahua rather than a Saint Bernard?”
The seller of the smaller bank – no fool – then delivered one final demand in his negotiations. “After the merger,” he in effect said, perhaps using words that were phrased more diplomatically than these, “I’m going to be a large shareholder of your bank, and it will represent a huge portion of my net worth. You have to promise me, therefore, that you’ll never again do a deal this dumb.”

Yes, the merger went through. The owner of the small bank became richer, we became poorer, and the managers of the big bank – newly bigger – lived happily ever after.

Monday, February 08, 2010

Lead by Example: Seth Klarman

Seth Klarman is the founder and president of The Baupost Group, a Boston-based private investment partnership. He is a topic of discussion on kaChing's Investing IQ App's "The Intelligent Investor" group (now with 1,270 members).

In the video, Klarman discusses his investment philosophy. He prefers to look for securities that fly below the radar, that are involved in complicated situations (and are therefore ignored by the investment community), stocks that are out of favor (kicked out of a major index or not belonging to one). He also prefers significant and illiquid securities over significant and liquid securities.

Klarman is worth listening to: Baupost manages $1.7 Billion for 40 families encompassing 700, and his book, "Margin of Safety," is $1,100 on (although the price of a book does not indicate the value of its content, but its lack of availability). Most importantly, his investment approach is to start cautiously by identifying all the risks and by avoiding them by hedging.

Klarman is rarely heard or followed by the media, unlike, for example, Warren Buffet. Yet, both investors have similarities in their approach to the selection of securities. For this reason,the Harvard Business Review interview (link below) is a worthwhile watch.

On Writing Margin of Safety:

Here is a link to the full interview provided by Harvard Business School.

These are some of the hi-lights from the video on leadership:
  • On leadership, lead by example
  • Be there and be available to staff (Klarman has an open trading desk as opposed to an office, even though he isn't a "trader")
  • Empower others: let others shine if you know they can do so
  • Set an example to colleagues on a having a balanced work-life

    Thursday, February 04, 2010

    Bubble in China

    Andy Xie is a former analyst from Morgan Stanley. He graduated from Massachusetts Institute of Technology with a M.S. in Civil Engineering, and obtained a PhD in Economics from Massachusetts Institute of Technology.

    Xie is worth listening to. He was one of the few economists who accurately predicted economic bubbles including the 1997 Asian Financial Crisis, dot-com bubble (1999) and Subprime mortgage crisis (2008).

    In his most recent post, Xie analyzes the impact of money flow to Chinese real estate, not to productive assets. With government policy promoting speculation, this action inter-connected with the zero interest rate policy found in the U.S. (my emphasis in bold): 

    Each belief depends on the key assumption that the Chinese government will let neither exchange rates nor land prices fall. The market psychology that the Chinese government is capping the downside for speculators has emboldened them to speculate in any asset class with a China angle.

    Yet the assumption has not been tested because the U.S. Federal Reserve’s low interest rate policy continues to drive money out of dollars and into China-related assets. When inflation forces the Fed to raise interest rates quickly, probably in 2012, this assumption will be tested. In the current speculative game around China, the force is the Fed’s zero interest rate. When that changes, I suspect few of today’s speculators will be around.
    Xie  comments on inflation in China:

    Money supply cannot grow faster than GDP forever. A prolonged gap between the two usually suggests an asset bubble, i.e. excess money supply is piling up in an asset market. But sustained asset inflation inevitably leads to consumer price inflation, either through the wealth effect on consumption or a cost push on the production side.
    Investors in China need to have a plan longer out:

    China’s monetary overhang in a more inflation prone environment augurs poorly for the inflation dynamic this year and beyond. The growth outlook, on the other hand, is dimmer. On the demand side, developed economies will continue to suffer high unemployment and property deflation. Despite a strong export showing in December, China’s exports are unlikely to grow as they did in the previous five years. I expect China’s exports will average single digit growth for the next five years, compared to 27 percent between 2003 and ‘08.

    His 2012 outlook:

    Indeed, 2012 is building up to be another crisis year. Governments and central banks did not handle the last crisis well. They did not reform a global financial system plagued by incentive misalignment and wild speculation. All the money governments and central banks released is turning into global inflation. And they resorted to bailing out speculators, laying the foundation for another crisis.
    This is a worthwhile read for investors who want to diversify geographically to other countries thought to have greater growth opportunities than that found in the U.S. A link to the full article is below.

    Chinese version:
    H/T to: The Big Picture