Take the world of venture capital. A few people like Harvard and Yale concentrated their investments with the four or five early-stage venture capital firms that had a real edge because they were the best known, attracted the best brainpower, and got the first calls from the companies. If you look at the history of start-up venture capital, you will find that a very few firms made most of the money, and they made it in just a couple of boom periods. Practically everyone else in a different period made mediocre or lousy returns.
Of course what happened was that when the huge returns were made by the clients of these few firms, envy rippled through the world of institutional money management and everyone set out to enter the business and firms started up to meet this demand for early-stage venture capital investment. In 1999 and early 2000, the amount invested was up about 10x. A lot of money was lost and I think something like this will happen again with these latest fads.
Many of you are on investment committees and I don’t know anybody who has successfully resisted this. There’s a new orthodoxy: you take all of the different fields of investment and somebody decides how much money is going into each field.
And then you have these beauty contests, deciding who’s going to manage the money in the distressed debt, early-stage venture capital, small caps, developing countries, etc., etc., etc. The people feel so busy and so virtuous, particularly after they’ve been successful for a while and other people who led them into it were also successful.
You can put me down as an enormous skeptic to this whole process, even though it’s worked so far.
I don’t see anything automatically wrong with doing some fixed-income arbitrage at selected times just because it was unconventional for some institutions to do it. I don’t think it’s wrong to engage in some activities in foreign countries or emerging markets or a lot of other places.
But this idea that you have these categories and then look for the right masters of the category – that is nuts by the standards of Berkshire Hathaway and Wesco.
Point 8. Smart People Can Be Irrational
The introductory text in economics, the best-selling one by [Harvard Professor Gregory] Mankiw, says that all intelligent people make decisions based on their own personal opportunity costs. So, when someone presented a company in an emerging market to Warren Buffett, Warren said, “I don’t feel more comfortable [buying this] than I feel about adding to our position in Wells Fargo.” He thinks highly of the company and the managers and the position they were in. He was using this as his opportunity cost. He was saying, “Don’t talk about anything unless it’s better than buying more Wells Fargo.” It doesn’t matter to Warren where the opportunity is. He has no preconceived ideas about whether Berkshire’s money ought to be in this or that. He’s scanning the world trying to get his opportunity cost as high as he can so his individual decisions would be better.
Why is it that the prevalent investment course in economics, what this Harvard professor [Mankiw] says, is so inconsistent with what all of these experts are doing? I have difficulty understanding it. It’s because of crazy waves of mental conformity and based on social approval. I believe in it the way I believe in baptism, because I’ve seen it done. [Laughter]
It’s hard for me to think that this many smart people can be so extremely irrational. This worshipping at the altar of diversification, I think that is really crazy. The idea that 10 different securities might not make an institution or a family securely rich?
Yet instead they listen to the professionals recommend having 300 securities in separate accounts, with cadres of experts and battalions of consultants, all charging them money and that is going to make them safe?! How can people be so uncynical about human nature?
Some of you may remember when a group of experts developed the idea of portfolio insurance. They created this trip hammer system and that gave us Black Monday and the market fell 20%+ in one day. Of course the idea just died with this one denouement.
Point 10. Some salespeople are selected because they know how to tell a beguiling story. Beware.
If you listen to the presentations of the people who are selling these various forms of expertise, they seem like reasonable people and you listen to their presentation and you walk away wanting to invest money with all of them. These people are selected because they know how to tell a beguiling story.
This system, with all the costs of getting in and out, with all these layers and experts and so forth, in many cases exceeds 3% per annum in costs. In a world when government bonds yield 5% and when returns from other assets are very likely to be converging toward 5%, that’s likely to eat up more than half of the expected return.
Everyone thinks they’ve found a way to rig the game. After all, Harvard doubled and tripled its endowment. So people say, I’ve seen the excellence at Harvard, so I want to get a high return, and there are these other people who tell them they know how to do it. And if you look at the last four or five years, they’ve done it. They are in for quite a ride I think.
Point 11. I think there’s a lot to be said when the world is going a little crazy around you, to at least put yourself in a position that if something really unpleasant happens, that it might be unpleasant but will be a non-event in terms of changing your life. [Prepare For Rainy Days When The Sun Is Shining]
Let me give you a different example, a different construct. I know a man, John Arrillaga [#346 on the Forbes 400], who was a star athlete at Stanford in a different generation. He got out of Stanford and started building little buildings around Stanford. He kept doing it and was good at it and of course there was no better market. In due time, he and his family had 15 million square feet, and the rents had gone up and up and up. The interesting thing was that instead of doing the normal thing real estate developers do, which is borrow, borrow, borrow, so that money earned goes up and up and up, John gradually paid off 100% of the debt on his buildings so that when the great Silicon Valley crash hit and three million square feet of his buildings went vacant, it was a total non-event – and, in fact, he could start buying buildings from others [who were distressed]. He now likes to build buildings for Stanford – and doesn’t take any compensation for it; he takes a loss. This has been a wonderful thing.
Here’s a man who deliberately took some risk out of his life. He has no regrets in his life. He was damn glad. I think there’s a lot to be said when the world is going a little crazy around you, to at least put yourself in a position that if something really unpleasant happens, that it might be unpleasant but will be a non-event in terms of changing your life. We all might consider imitating John Arrillaga as things get crazier and crazier.
Point 12. The Market Has Gone Crazy. If You Happen To Be Playing Big Brass Tuba When It Rained Gold ….. Well Good For You But Don’t Think You Are Now A Genius ‘Cos You Could Just Be An Idiot Who Happened To Be Playing A Big Brass Tuba
Well, how crazy are things? Let’s look at the obvious bubbles. Saudi Arabia had a huge bubble; it was the South Sea bubble all over again. People bought into things just because they were going up, and the market is down 50%. Kuwait did the same a few years ago. There was just an orgy like the South Sea bubble. But Kuwait is so rich that when it happened, they just bailed everybody out.
The wealth of some of these oil countries is amazing. Qatar decided it wanted a medical school and 300-bed hospital. It cost $9 billion and it was like taking it out of petty cash. In the history of the earth, I don’t think there’s ever been so much wealth per capita – and it’s only about 60 miles square. The world is not entirely a fair place when it leads to these ridiculous bonanzas.
I remember a story they used to tell in Texas when I was young. When some idiot got rich, they’d say, “Well, old Charlie was out in the field playing the big brass tuba on the day it rained gold.” A lot of people have become rich lately who were playing the tuba on the day it rained gold.
If you get capital gains taxed at 15% and you get stock options in something that goes crazy or a hedge fund that has a great year…There’s many a man that decides he wants three Chagalls and a $15 million apartment very fast…
The world has signs now that are somewhat disturbing. The way things are going is that every asset class I see is priced on a fairly rich basis. If you buy a really nice apartment house, with the costs of running it and replacing carpets, etc., it yields less than 5% if you buy it outright. In Europe, you can find office buildings that are yielding 3%.
There are very liberally valued assets in practically every asset class. Junk bonds seem to be pretty junky. Whatever premium they’re providing in terms of yield seems to me to be offset by the increased risk of not getting your principal back.
The markets are picked over. Part of the reason they’re picked over is because so many people like you can afford to come so far and think about value investing.
Notes from 2006 Wesco Financial Annual Meeting – By Whitney Tilson