Charlie Munger's 3 Categories of Investment: In, Out & Too Tough

94. Berkshire Annual Meeting 2017 – Part 4 – Wisdom Guide 19 – 24

Ref: Adam Blum’s 2017 Berkshire Hathaway Annual Meeting Notes – May 6, 2017

Guide 19. Career Mismatch: (Is like) getting to Carnegie Hall by playing violin and then walking on the main stage and being given a piano to play.

Q26 – intermodal will do very well, but car loadings peaked in 2006. Trains have big advantages over trucking in many respects. It’s not a volume growth business but still is a good business. He likes the West US better than the East US for rail. They can’t expect aggregate car loadings to increase though.

Q27 – any potential successor with proven capital allocation abilities will be at the top of the board’s mind. Capital allocation is incredibly important. The company has $280B of shareholder equity, and in the next seven or eight years, we will have to allocate $400B or more. Berkshire Hathaway will be an aggregation of businesses in ten years with more allocated capital in that period than in the entire prior history of the company. This capital allocation needs to be very close to the successor’s main talent. If the successor hasn’t done it but has other talents that cause his career rise, it’s like getting to Carnegie Hall by playing violin and then walking on the main stage and being given a piano to play.

People have to have a money mind. They can be very smart but make very unintelligent money decisions; their wiring works that way.

Munger: “Also there’s the option for the successor of buying in stock (stock buyback), which is not hopelessly unintelligent.”

Buffett: “A money mind will know what needs to be done. It’s not complicated when thinking straight about it.”

Guide 20. Add value My Friends, Add value: In all the professions, there is value added by professionals.

Q28 – value of money managers – would Buffett pay a fee to Munger for his counsel?

There are maybe a dozen people he has known who he’d have predicted or did predict that the person would beat the average over the long term. Charlie is one of those. “Would I pay financial advisors as a group? Not a good question. I’d have paid $100K for Babe Ruth to come over to the Yankees from the Red Sox in 1919 but not for many other players. If you hire an obstetrician, they will do a better job than someone off the street. In all the professions, there is value added by professionals. But in the investment world, it isn’t true. They can’t do better in the aggregate than the person who just sits tight. Active guys here and there will outperform, but how do you find them?”

Munger: “It’s even worse. An expert who is really good at money management suffers terrible performance problems when he gets more money in. The investing world is a morass of wrong incentives, crazy reporting and a fair amount of delusion.”

None of the 12 folks Buffett would have invested with would even beat the S&P 500 with $100B, only with moderate sums. It’s a interesting profession when hundreds of thousands of folks are compensated by selling something that can’t be true. “Salesmen will always make huge money by selling something magical.” In any other field, 2% management fee on a poor performing fund would be viewed as tragic. “We pay Combs and Weschler $1mm a year plus what they do to beat the S&P, and this just doesn’t happen with other money managers. They charge 2 and 20, because they can’t get 3 and 30.”

Guide 21. A stupid mistake today can look even more stupid tomorrow. Ouch!

Q29 – Precision Castparts – made 2 bolt-on acquisitions already because they have an extraordinary manager and are in a terrific position in the aircraft field. They will make more bolt-ons over time. The only big purchase adjustment is the amortization of intangibles of $400mm. Buffett doesn’t regard the asset as actually being diminished at that amount over the period. He’s also not tremendously worried about the 3-D printing of aircraft parts. “Can anyone do it better or cheaper?” Overall, he feels very good about it – the company has long term contracts and is viewed as a trusted supplier. Reliability in that space (aircraft engines) is incredibly important.

Munger: “It’s a very good business purchased at a fair price but no bargain like we used to see in the old days – but that’s ok.”

Buffett: “On the topic of adjustments, starting in 2018, there will be an accounting nightmare, because we will have to mark publicly held equities to market through the Income Statement. This will confuse the heck out of GAAP earnings. Berkshire Hathaway is not a Wall Street securities firm, so this is just a big distortion. Accounting is not supposed to describe value but can be useful in specific situations for estimating value.”

Munger: “You can blame the auditors for that one – that was really stupid.”

Buffett says they will do their best to explain what to use and ignore in coming to a judgment in valuing the Berkshire. Holdings.

“What can be silly this year will become absolutely ludicrous next year.”

Guide 22. “I don’t think we mind killing chickens, and I do think we are against nuclear war.”

Q30 – probability of duplicating track record in China – Charlie says it’s like determining the order of precedence between a louse and a flea. The stock market there is cheap and has a bright future, but there will be growing pains. He has an opportunistic way of going through life and doesn’t have any rules about what to look at.

Q31 – 3G cost-cutting – They believe in having a company as productive as possible – and all gains in this world have come from productivity; they have been doing that in every industry since 1776. Buffett prefers to buy companies that are already running efficiently, because don’t enjoy the process of getting more efficient. And there are political consequences that do hit businesses from cost cutting, but 3G focuses on product improvement and innovation. “If you had the cheesecake at lunch then you’ll agree with me.” They have been through the process of buying a textile business that went out of business or a department store that went into oblivion. It’s not much fun cutting jobs.

Munger: “There’s nothing wrong with increasing productivity. But just because it’s right doesn’t mean one should always do it. It can be counterproductive from the bad publicity.”

Q32 – raising share buyback threshold from 1.2x book value – When the time comes that they can’t put the money out at a rate of return that is justified, they will repurchase cash or issue dividends. At the moment, they’re still optimistic about deploying capital, so Buffett wouldn’t move the price threshold much closer. It’s already a narrow spread to the market price. The last thing they want to do is own something at 100x earnings if the business can’t grow. They shouldn’t use shareholder money that way. But they’re sure that sometime in next decade, there will be markets where they can do intelligent things on a big scale; “We can’t come back in three years with $150B in cash and think we’ve done something brilliant.”

Munger says the answer is “maybe.”

Q33 – CTB subsidiary – makes equipment for poultry growers – Buffett can’t address their rights violations but will put the gentleman in touch with people who can fill him in. Buffett is pessimistic on weapons of mass destruction, though nuclear isn’t as likely as biological or cyber. It’s the number one problem of mankind.

Munger: “I don’t think we mind killing chickens, and I do think we are against nuclear war.”

Guide 23. We don’t want to go back to subsistence farming. I had a week of it and hated it growing up. I also don’t the miss elevator operator sitting there with a crank. Why would we do it (fire people)? We had to in the past when businesses were dying. There’s some political fallout but nothing that isn’t moral.

Q34 – Todd and a Ted manage a proportion of Berkshire Hathaway capital that’s similar or higher than when each one started – it’s tougher to run $10B than $1-2B. The hiring decision has been terrific. Each has made more money than Buffett would’ve made and has been a terrific help beyond just money management. They’re smart, have money minds, are good at investment management and absolutely fist class human beings. Charlie gets credit for Todd and Warren for Ted.

Munger: Shareholders are very lucky to have Ted and Todd, because both think like shareholders. Buffett: “It’s hard to find young, ambitious talent who don’t put themselves first; giving them another $30B each won’t improve their lives or performance.”

Munger: “It’s a lot harder now (with $90B in cash to deploy).”

Q35 – A shares voting rights diminishing? Are they thinking of buying back A Shares on the private market? Depends on the price. Buffett has given away $2.8B of A shares each of last two years. This is immaterial – 7/10ths of 1% of the company’s market cap. They bought a block of 12,000 shares of A in 2012 off-market, because it was offered at a discount to the intrinsic value. Buffett said he was comfortable buying it up to 120% of market value. Ture, the foundations he donates to may build up a position over time as they accumulate Berkshire stock before selling it, but they will have to sell it as they spend on their causes. Buffett likes the idea of a fair number of votes being concentrated with people who believe in the culture. If they can buy A shares back at an intrinsic value discount, they will do it again.

Q36 – Do you know any eligible bachelors in NYC area? Joking. BofA warrant with option to convert into common stock – if the price >$7, whether or not they keep the stock, they will exercise it before expires. The income from the investment increases if BofA paid $0.11 per quarter dividend (>$300mm a year), so if they get to that level of dividend, they will exercise since the common dividend would exceed the $300mm. Would they want to keep the stock? As of today, he would use the warrant to convert and keep the common stock. Who knows in 2021, when they can sell.

Munger: “It’s very wise for a woman who owns Berkshire Hathaway and is good looking to put her picture up like that.”

Buffett: “We might actually start selling ads in the annual report.”

The BofA purchase came to him in bathtub, and he spent a lot of time there ever since, and nothing’s come to him, so he may need a new bathtub.

Q37 – 3G question – 80% of the US population worked on farms 100 years ago. Any industry tries to get more productive. If one can do business with fewer people, that’s what American businesses do – it’s very painful but absolutely essential to become more productive as that’s the only way to have more productivity and consumption per capita.

Munger: “We don’t want to go back to subsistence farming. I had a week of it and hated it growing up. I also don’t the miss elevator operator sitting there with a crank. Why would we do it (fire people)? We had to in the past when businesses were dying. There’s some political fallout but nothing that isn’t moral.”

Buffett remembers the old story of seeing a bunch of men working digging a trench by hand with idle digging machines in the background. Someone asked why not use machines to do the men’s job? The answer was “well, that would put them out of work.” The questioner said, “give the men spoons at least.”

Q38 – buying power – They won’t come close to hitting their $20B cash floor. They could use debt for something that lit their fire, which is unlikely today. They could do a very large deal if they thought it was sufficiently attractive. They spent $16B when they were much smaller over a three-week period in 2008 and never got to a problem where they weren’t sleeping at night.

Munger: “$150B is probably too big for us.”

Buffett: “We both would do a very big deal.”

Munger: “We don’t have to agree perfectly.”

Buffett: “If we found a deal that makes compelling sense, we would do it.”

Munger: “Now you’re talking.”

Guide 24. On Valuaton: The best method is to calculate intrinsic value, but they can’t be precise.

Q39 – 3G’s Jorge Paulo Lemann as a Berkshire board member or successor – It would complicate things. Buffett loves being their partner and will do more with them. The board may not change in next few years, and his successor is likely to have been with Berkshire Hathaway.

Munger: “My back hurts, and I come to this meeting to indicate to the shareholders that they probably have seven good years to get out of Warren.”

Q40 – Fruit of the Loom hasn’t been hurt by online so far, but anyone who thinks they’re insulated from it is incorrect. The furniture operation is also setting a record this year; it’s hard to see the effects from online (outside of their own online operations). There are a lot of things they didn’t see ten years ago that then materialized, that said. Nebraska Furniture Mart’s online business is now at 10% of total volume, but a significant amount of the online buyers still go to the store to pick out the furniture.

There are no illusions that ten years from now will look anything like today. One hundred years ago, department stores offered incredible selection and a big, exciting experience of variety, decent prices and streetcar accessibility and then along came the shopping centers followed by the discount stores and now the Internet, where transportation has been taken care of entirely. They are much expanded in assortment, more convenient and have lower prices. A lot of questions in retail are very interesting to watch.

Munger: “It would certainly be unpleasant to be in the department store business. We are fortunate ours failed so badly that [Berkshire director] Sandy Gottesman talked us out of it. We got lucky.”

Q41 – book value has a lot less relevance than it used to because of so many private holdings at Berkshire. The best method is to calculate intrinsic value, but they can’t be precise. The probability is exceptionally high that 120% of book value understates intrinsic value. If Berkshire were all public securities, 120% would be too high, but there are so many private holdings with unrealized value.

Munger likes it when marketable securities go down and owned businesses go up.