Investment Wisdom

75. Wesco 2006: Let’s Learn – Part 1 – Points 1-6

Point 1. It’s not entirely an unpleasant duty because I like people to think the way I do.

OPENING REMARKS

Welcome to the Wesco annual meeting for the die-hard groupies of Berkshire Hathaway. [Laughter]

[Munger briefly went through the official business of the annual meeting, introducing the directors, etc. At one point, he said that there are 7,119,807 shares of Wesco outstanding, and commented: “That has not changed since I was first affiliated in any way with Wesco. We must be the only corporation in America with that attribute.”

He then concluded the annual meeting and, as he’s done in past years, began with some remarks, after which he took questions for roughly two hours.]

Now we will begin our question-and-answer session, preceded by extended comments … by me. [Laughter] The reason I’m making these extended comments is that so many of you have come from so far and so many of you are devotees of the same approach to life as is demonstrated around Berkshire and Wesco. Under these circumstances, I feel obliged to do it as an unfortunate aspect of my duties. It’s not entirely an unpleasant duty because I like people to think the way I do.

Point 2. On Money Management: (Although he laments too many brains going into money management …) I think this is good for the people in it because if you know enough about money management to be good at it, you will know a lot about life. That part is good.

One unfortunate aspect of my practice is that I talk to a great many money managers who want to do better – do their function in life way better than other people do. I have very mixed feelings on this subject because I regard the amount of brainpower going into money management as a national scandal. We have armies of people with advanced degrees in physics and math in various hedge funds and private-equity funds trying to outsmart the market. A lot of you older people in the room can remember when none of these people existed. There used to be very few people in the business, who were not very intelligent. This was a great help to me. [Laughter]

Now we have armies of very talented people working with great diligence to be the best they can be. I think this is good for the people in it because if you know enough about money management to be good at it, you will know a lot about life. That part is good.

But it’s been carried to an extreme. I see prospectuses for businesses with 40-50 people with PhDs, and they have back tested systems and formulas and they want to raise $100 billion. [Munger is referring to Jim Simons, who has compiled one of the best investment records of all time with Renaissance Technologies, compounding net to investors at roughly 35% annually since 1982.] And they will take a very substantial override for providing this wonderful system. The guy who runs it has a wonderful investment record and his system is a lot of high mathematics and algorithms with data from the past.

Point 2. Rationality is a High Moral Duty

What is the central theme that the people in this room represent? I’d argue that it’s rationality rather than to make more money than other people. I’d argue that rationality is a high moral duty. It’s the idea the binds us all together. I think that is a really good idea. It requires that you avoid taking in a lot of the nonsense that’s conventional in your time. There’s always a lot of nonsense in anyone’s time. It requires gradually developing systems of thought that improve your batting average and thinking correctly.

Point 3. When People Are Demoralized, There Can Be Investment Opportunities

Regarding Wesco, there’s not much to say beyond what’s in the annual report, so I won’t talk about it unless I’m asked a question. Regarding money management, I’ll talk at some length because we’re in quite a period. When I was young, professional money management consisted of owning some mixture of stocks and bonds. Early on, bonds were respected and stocks were regarded with some fear, thanks to the early 1930s and the behavior of the capitalists in the robber-baron days. For a long time, stocks yielded dividends that were twice as much as the interest rates on bonds. It was a wonderful period to be buying stocks. We profited from others’ demoralization from the previous generation.

Point 4. (On Unrealistic Expectations of High Returns) “I need it and I want it and therefore I should have it.” My father used to have contempt for this attitude.

It used to be that if you owned stocks, you could get an extra 7-8 points of return per annum, but if you think that’s true today, you probably believe in the tooth fairy. If there’s any efficiency at all in markets, all of these professionals will have asset-class [returns] converge.

As this convergence became obvious to a lot of people at foundations and pension funds, they basically said “It won’t work very well for me if I get lower returns, because I need and want [higher returns].” So they reasoned as follows: “I need it and I want it and therefore I should have it.” [Laughter] My father used to have contempt for this attitude.

Point 5. There was a time when junk bonds, purchased with reasonable care, produced enormous returns. [Sic: Don’t Try It At Home.]

So institutional investors have decided that they want way more than the result that can be achieved from the standard mix of stocks and bonds. So the system morphed into a series of consultants. The consultancy system works as follows. It’s like a gigantic farm, stretching as far as the eye can see. They decided to manage this farm in an intelligent way and somebody had to decide how much soybeans to have, how much corn, wheat, pigs, chickens, etc. Once we decided to do that, then we decided to subdivide responsibilities by having a competition. Those who think they’re excellent chicken raisers will compete for the job of raising chickens. All the guys who think they know how to grow soybeans will compete for the job of growing soybeans, etc. And then they have these beauty contests judged by the consultants.

Those of you in money management are no doubt familiar with this process. The interesting thing about this, the reasons that it spread so mightily, is because it coincided with a time when stocks and bonds were collapsing and disappointing, so a lot of the people who’d gone to this system profited. The truth of the matter is that there were remarkable opportunities from taking leveraged positions. There was a time when junk bonds, purchased with reasonable care, produced enormous returns [he’s referring to the collapse and near paralysis in the junk-bond market in late 2002]. And the same thing in different forms also generated big returns.

Point 6. Financial Instruments Which Makes You Money Can Be A Disaster If There Is a Convulsion.

Bonus Point 6A. Don’t Assume Good Investment Records Are All Skills, It Can Be By Accident

I recently met a man with more than $5 billion under management. Institutions found him via consultants, incidentally, even though he’s not that hard to find. [Laughter] What he does is buy participations in first-lien bank loans, probably $50 million a pop, and he selects the ones he thinks won’t default, and he gets 250 [basis points] over LIBOR. Then he issues bonds against his purchases until he’s leveraged about 6x. These are 10-year bonds that can be prepaid at will but can’t be called. The bonds yield a little bit over LIBOR, so maybe he’s getting a two [percentage] point override. You don’t have to know very much about mathematics to know that this yields a very handsome return on the equity of the people who put it up. So the institutions put up the equity and this man takes a nice fee and 20% of the profit. So far, there have been no defaults and the institutions have gotten over 10% per annum – and the guy’s gotten rich.

I see this repeated over and over and over again. So why don’t we all leverage someone’s high-yielding loans and make our own 12 or 13 or 20% with our own money. In the first place, it’s inconvenient to do. You have to work at it, understand the covenants. I regard what this man is doing as pretty intelligent. Taking first-lien positions, it’s not totally crazy. My guess is that investing with this man is not the dumbest thing these institutions are doing. It has some elements of rationality. It’s worked very well, but it’s created a lot of leverage in the system. If there was a real convulsion of some kind, all of these things would encounter trouble. But short of a convulsion, everything would be okay. It’s sort of like earthquake insurance. Most years when you write earthquake insurance, you pocket the premiums and look very intelligent. If you do that with someone else’s capital under a profit-sharing formula, it would really be intelligent.

All of this stuff that people are investing in – it’s like the man who promises you an extra yield on a bond, provided there’s no major earthquake (earthquake in some general sense). The investment world is just choke full of this stuff and it’s worked very well so far. Everyone’s made a lot of money. The people like Harvard, who got into fixed-income arbitrage really made a lot of money. The rest of us were asleep when Harvard was doing this. It wasn’t that hard when they told us that interest rates were going down, down, down for a long time. There was an easy, idiot-proof way to take advantage of this, with very little risk, but it involved using unconventional techniques, using the [bond] repo system to go long 2-year Treasuries and go short 1- year Treasuries on a highly leveraged basis. People got very rich on carry trades like that. They not only made a lot of money on the interest, but also on the valuation as the interest rates kept coming down. These unconventional people suddenly got very good investment records, partly by accident.

http://www.valuewalk.com/wp-content/uploads/2014/05/Charlie-Munger-2005-2013-minus-Harvard-Westlake.pdf

Notes from 2006 Wesco Financial Annual Meeting – By Whitney Tilson