Poor Charlie

The average insurance company writes something like 1.0x equity and each dollar of written premiums produces around a dollar in float (this will vary depending on whether they write property or casualty business). Berkshire, on the other hand, writes something like 0.2x equity and each dollar of written premiums produces around two dollars in float (it used to be more). So as long as they’re reserving properly, Berkshire is risking a fraction of its equity on their insurance book relative to the average insurance company (but still generating a disproportionate amount of float). This structure lends itself to risking more equity capital on investments, especially when you have a large cushion in deferred taxes. I don’t think Berkshire’s model is that aberrational. The Bermuda reinsurers write a similar amount of business in relation to equity (but generate less float as it’s all short-tail business) and have around 1x their equity capital in equity investments There’s also several mainstream insurers that follow the model, too (Cincinnati Financial comes to mind).

I’m also surprised farmland has held up so well. Prices are still above $10,000 per acre in a lot of areas. At $10,000 per acre, even the most productive farmland is yielding less than a short-term government bond. I dealt with this problem a few years ago. We had farmland that had been in the family for over 150 years. It was immaterial in relation to overall resources and generated little cash (in relation to capital value), but my family had a strong emotional attachment to it. It was indeed tough to get past these non-economic factors during the sale.

I would also like to know more about this. Li Lu has talked about it a few times. He said there were only a few concentrated investments and most of the ideas came from hearing practitioners speak to his class. Two of these ideas were American Tower and Lukoil (or Gazprom?). My understanding is that he was also involved in Russian vouchers, which may be how he came to own Lukoil. (How does a graduate student get access to the Russian voucher program?) The main lesson I take away from his experience is to be opportunistic. How many CBS students heard speakers pitch investment ideas over the years? It’s probably in the thousands by now. And how many of them actually did anything with these ideas? Maybe a few dozen—including Li Lu. What makes Li Lu unique though are the circumstances: he was a refugee without resources who was still learning the language and customs of a new country. And yet he was still able to see what most of his fellow classmates couldn’t. Charlie Munger has mentioned that he likes to partner with people who could be parachuted into a new country without any resources and still make a fortune. After understanding Li Lu’s background, it’s plain to see why Munger chose him to manage his money.

The Hyundai investment is interesting. The whole premise behind the small-size caveat is that it enables them to take their skillset to a bigger investment universe. But if that’s the case, why did Munger buy Hyundai? When he was making his investment (2013-2014), I remember finding many opportunities in Korea that looked a lot better than Hyundai. I also know Munger knew about some of these because Li Lu presented one at CBS. The fact that Munger had direct knowledge of these opportunities (via Li Lu) and had access to them (via the foundation’s smaller capital base) and still made a poor investment speaks to the fact that size isn’t the limiting factor here. Compounding at 50%, whether it’s with $1 million or $1 billion, is tough. That’s not to say it isn’t doable—it’s just tough.

Poor Charlie 1) How did you find out about the Munger foundation's investment in Hyundai? Is there a list or filing made? 2) Which Hyundai entity is it? (There are quite a few - Hyundai Motors, Hyundai Engineering & Construction, Hyundai Dept Store, Hyundai Fire & Marine, Hyundai Green Food, Hyundai Merchant Marine, Hyundai Heavy, Hyundai Corp, Hyundai Mobis, Hyundai Steel, Hyundai Mipo) Thanks in advance. Run a search on any database for the ‘Alfred C Munger Foundation’ (named after his father). For example: https://projects.propublica.org/nonprofits/organizations/952462103 (See page 21 of the 2016 filing)

Buffett has talked a lot about the 1950s as his best decade, so I would use that as a reference. If you look at his holdings from back then, you’ll notice that most of them were (a) priced under 5x earnings, (b) growing at a decent clip (i.e., 10%) and © trading in some off-the-map market (think of the Atled example he’s talked about a few times). Also, most of his large investments from back then were coattails—IDS (Murchinson); Western Insurance (Duboc); Philadelphia & Reading (Graham); Geico (Graham); North American Fire (Ahmanson); Rockwood (Pritzker); Crane (Evans); Eltra (Wattles); Getty Oil (Getty). Could he and Munger still find these situations today? I think so. Consider, for instance, the investments Himalaya has made overseas in the last twenty-five years. Most of these were even cleaner (better business, capital structure, price, etc.) than the investments Buffett was making in the 1950s. I would rank them up their with Belridge, which Munger often cites as one of the best investment opportunities of his life. That being said, just because it can be done doesn’t mean that they could do it. Take Munger’s smaller pools of capital—The Daily Journal and his foundation. What’s the return on the Daily Journal’s investments over the last five years? Not 50%. How about his foundation? The only large investment he has made in the foundation in the last five years (Hyundai common and preferred) is probably down by 50%. If it were indeed as easy as Buffett lets on, I think the returns in both these vehicles would’ve been a lot higher. [From my own experience, the single-most important factor to earning high returns is knowing where to look.]

The Great Salad Oil Swindle is available on openlibrary.org (https://openlibrary.org/works/OL16056018W/The_Great_salad_oil_swindle._On_the_career_of_Anthony_De_Angelis._.). The Jack Henry book is a lot better than the Salad Oil book.

I have a question for the real estate / retail people: Why do most companies use 6-7x to capitalize their leases? Assuming it’s a net lease, the tenant’s rent expense should be close to the owner’s NOI. Owners capitalize their property at 16-17x (cap rate of 6% for Class A), so why should the tenant capitalize their lease at 6x for ROIC calculations?

Could you elaborate on the healthcare bubble/fraud. I’m not really familiar with Obamacare—who would be fighting for the last dollar and why would people be calling in their neighbors? Thanks

Oddball, as usual you bring up some great points. I agree 100%: whether it's a guy running an operating business, someone running money or a musician like your brother, marketing beats out talent. In fact, I've seen how this works first hand: I grew up in a very wealthy part of the country and over half the people were there because of better marketing—of themselves, their products or during the sale of their business. If these people had to survive on skill alone, they would have all starved by now. I also think you see it between the US and Europe: there are a lot European companies that would win on product alone, but they get killed because their US competitors know how to market. But just because marketing works doesn't mean you should always use it. There's more to life than being the guy with the biggest AUM and the most money—at the end of the day, you need to be able to look at yourself in the mirror.

Thanks a lot for taking the time to put this transcript together!

I have a different point of view on this stuff than most: I think running money for other people is different from running an operating business. It’s a fiduciary responsibility—like being a trustee in a reorganization or in a friend’s estate. A person earns the right to be a fiduciary (i.e., a trustee of a friend’s estate), and you market for the position in the sense that you have a long track of being a responsible, ethical and capable person. I don’t think it’s like selling Clorox bleach or something. This is not to diminish the role of marketing at an operating business—I agree with you 100% that it’s an essential function.

So essentially they all lied about their track record? Did you ever follow up on that and ask them about the reason for the discrepancy? - B They were more half-truths. What I found out was that most private equity IRRs are manufactured (for lack of a better word). For instance: LPs would commit to a fund for 10 years, but they wouldn’t get a capital call until the buyouts were done (although they would still be charged a 1.5% management fee). LPs would wire their money when a deal was signed; the sponsor would take control of the company, improve efficiency (a la 3G) and dress up the numbers; the company would be marketed soon after at a few turns higher (e.g., bought for 8x- and sold for 10x-EBITDA); and then the company would be sold and money wired back to investors or paid out in merger stock. The IRRs would be measured over the life of the buyout, which was like 6 months to 2 years, not the life of the fund. Put another way, this would be like someone giving me 10-year money and me doing 4 or 5 arb trades where I earned high IRRs over a few months but low overall cash-on-cash returns over the 10 years. My understanding is that it's a fairly common practice.

This is an interesting discussion topic. There are investors I would literally pass up a dinner date with Heidi Klum to sit down with. These people, however, would not be members of the marketing machine Oddball describes. The people I admire are capitalists—people who’ve built up fortunes using their own balance sheet. Guys like Jay Pritzker, Ian Cumming, Herb Allen Jr., Herb Siegel, Charles Koch, Sid Bass, George Ohrstrom Sr., Thomas Mellon Evans, George Baker, Byron Smith, Rales brothers, etc. Because they had no need for outside capital, they never marketed. Most of them, in fact, went out of their way to avoid publicity. They built their fortunes by being very, very good capitalists (and maybe a little nepotism, too). I tend to discount the New York 'value' money manager crowd. Some of them are talented, but most of them are more marketing guru than investment guru. To give you an example of the marketing involved in professional money management, consider this. A while ago we were selling a small business. Most of the prospective buyers were private equity types, and they would all talk about their amazing records—20%- and 30%-range. They were all impressive characters and had a wonderful pitch. Yet when I looked up their audited numbers, very few of their funds had even managed to double. These were 10-year funds that leveraged up a lot, and they couldn't even double their investors' money (a 7% compounded return)! These people aren't skillful capitalists—they're salesman.

Thanks for sharing this!

See link for handout: https://www.dropbox.com/s/tfwhsgo6n45iasv/DJCO%202017.pdf?dl=0 Also, I came in late and wasn't able to grab the annual report. If someone has it, would you mind posting Munger's Chairman's Letter? Thanks.

Wow! A big thanks to all the political commentators for this first-class exhibition of drivel—You’ve reminded me what the breakdown of otherwise well-functioning cognition looks like and why I never want to go there.

My point on WMT being unable to fund 30% growth had absolutely nothing to do with if funding came from a regional bank or BB. My whole point was that their finite (20%-something) ROEs were insufficient to provide the internal funding engine (growth = ROE * retention rate), and so they HAD to go get outside capital to grow at 30%. Whether it was Shylock or Goldman Sachs makes no difference at all. (Please note - the reason for the WMT/AMZN comparison I made was to demonstrate the merits of a negative capital business that is growing. Talking about funding sources was just a way of making my point.) Using ROE as one of the factors that limits growth (the other being retention rate) is not some random idea I cooked up – it’s a fact of capitalism (please look it up). Businesses can only grow as fast as their ROE will let them (before they are forced to go to the capital markets). Once again: Growth Rate = Return on Equity X Retention Rate. What matters is the ability to convert net income into free cash flow. Only looking at cash flows as a % of revenues would dismiss all the high return businesses that generate their economics from the 'high-turn, low-margin' model. (BTW I'm not talking about the investment merits of AMZN. I would never pay those prices for any business) I'd like to think we're just talking past each other, but I'm leaning more towards either you're not reading my posts correctly or you don't understand some of things I'm talking about.

Nice post, however I do find your comments on AMZN (as opposed to WMT) a bit confusing. You seem to be arguing there is some kind of fundamental distinction between the 2 businesses which justifies a different capitalization. ROA is where the money is, and WMT's is about double AMZN's. WMT has a higher ROIC as well. Of course, you can argue that part of AMZN's return is "intangible," e.g. wider moat/ market dominance/ whatever. AMZN's valuation is based on its presumed ability to be a good business with stable returns (like WMT currently) in the future, not on some sort of redefinition of the valuation standards for a retail operation (IMO). One you abandon the idea that the value of a business is what it could be liquidated for in cash at *some* point in the future, I think the process of valuation gets a bit dicey. The distinction I was trying to make was between the two most common reasons a company would operate with negative equity on the b/s (i.e., more liabilities than assets): [*]They are highly leveraged due to the sponsors extracting cash via cash-outs (dividends/recaps/sale to a leveraged buyer) or buybacks. [*]They are able to manage their capital so efficiently that the operating assets needed to produce the goods and services they sell are less than the liabilities they owe to their trade creditors (and to some lesser extent employees – accrued expenses – and customers – deferred revenues). I then went on to say that businesses in the second category can be amazing performers (Operationally. Not necessarily from an investment standpoint) because they are not constrained by their funding sources: A business can only grow internally as fast as their ROE allows them (growth = ROE * retention rate). If you earn infinite ROEs (no or negative invested capital), your growth rate is constrained instead only by the rate the market will allow you to grow at. Kind of like having a car that’s limited only by the length of the road and not the speedometer. As for AMZN vs WMT? In my post I don’t think I was really making any distinction between the two. I do think there is a very interesting lesson to be learned by making a distinction though. Consider this- Take a look at Wal-Mat during their earlier years as a public company (70s/80s – the financials are on their website). WMT was a monster. They had almost limitless ways to productively deploy capital and were growing by something like 30% (going off memory?). However, their growth was still constrained by some finite ROIC. In fact, because their ROE was below their growth rate they had to go outside for capital a bunch of times: on b/s sheet leverage was something like ¼ of capital and they did a number of equity raises. They also used a ton of leases that didn’t show up on the b/s sheet but are (to me) clearly a funding source. Anecdotally, to show just how capital constrained their growth was consider that Sam Walton’s daughter (paraphrasing from the autobiography) told her elementary school class that the thing that terrified her most in life was the debt her family was taking on to fund the business (apparently this was what the dinner table conversation revolved around). Amazon (focusing on the retail business) is different. Their ability to efficiently manage assets (DIO = 40-something and fixed asset turnover = 20-something) and stretch out non-interest bearing, revolving liabilities (AP, accrued and deferred revenues) enables them to operate without any tangible capital. If they don’t need any capital to run the business then, by definition, they produce infinite ROEs (if you exclude cash, that is indeed the case). And if they produce infinite ROEs then they can self-fund as much growth as they want to take on. This is most evident in AMZN’s ability to grow at 30% and still produce tons of cash. Some of this cash does of course come from the crazy option issuances and operating leases (similar to WMT in the 70s), but they still produce an insane amount of cash for an unprofitable (GAAP-basis) company that is growing at such a fast clip. (BTW I don’t own AMZN; just think it’s an interesting case study when compared to WMT.) One more thing: you mention “ROA is where the money is.” I would say ROIC is where the money is. Focusing on ROA and not ROIC (FCF / (Working Capital + Fixed Assets – cash not needed to run the business)) means that your operating liabilities don’t matter. Cheap, durable, revolving liabilities are what Buffett built his career on. They’re also the only reason most businesses earn a return high enough to justify their existence (ROE > treasuries). Consider this passage from Buffett: Any company's level of profitability is determined by three items: (1) what its assets earn; (2) what its liabilities cost; and (3) its utilization of "leverage" that is, the degree to which its assets are funded by liabilities rather than by equity. Over the years, we have done well on Point 1, having produced high returns on our assets. But we have also benefitted greatly to a degree that is not generally well-understood because our liabilities have cost us very little. An important reason for this low cost is that we have obtained float on very advantageous terms.

This is a good discussion topic. I think it’s important to make the distinction between a business that truly doesn’t need any tangible capital and those that have negative equity due to the capital structure. Take, for instance, a company like Transdigm. TDG is basically a publicly traded LBO. Their negative equity comes from constantly doing leveraged recaps (I believe they have a stated goal of maintaining leverage at 4x- to 6x-EBITDA). As far as operating assets needed to run the business, there’s really nothing special about TDG: DSO = 60; DIO = 170; DPO = 40; and fixed asset turnover = 10. Of course, what TDG lacks in capital efficiency they make up for with +50% operating margins. But the fact still stands that they need to make investments in both working capital and fixed assets to operate the business. A business like Amazon’s retail operation, on the other hand, is a true negative equity business. If you go back and look at AMZN’s financials when they were just retail (pre AWS – I’m using YE 2007 #s), it took negative $1.1b in tangible capital to generate almost $15b in sales. Said differently, AMZN generated 7 cents in cash (1.1/15=.073) per dollar of sales at zero margin. They were able to do this by efficiently managing assets (DIO = 38, FA Turnover = 27x) as well as delaying payment of liabilities (DPO = 89). One more thing: negative invested capital really only comes into play if the business is growing. If the business is flat-lining, all earnings dollars are created equal (I’d actually argue that an equivalent amount of earnings is worth more from the capital heavy business because cash can almost always be extracted from a bloated balance sheet – e.g., Dempster Mill). And if the business is declining, earnings dollars from a capital heavy business are way more valuable than earnings dollars from a negative capital business (a negative capital business consumes cash as it shrinks – e.g., Ambassadors Group or the newspaper industry). But if the business is negative capital and growing, you can grow as fast as the market will allow and still be awash in cash. This is the business you buy and hold on to with both hands.

Highlight of my day. Thanks Dempster!

Hi Dempster Diver This is the first I've heard of Portland Gas as well. If you haven't already looked, I would recommend browsing the footnotes to Snowball. The footnotes have fairly comprehensive information regarding BPL. Another option, of course, would be to contact Alice Schroeder directly. Would you mind sharing the Sanborn Map ARs you've found? I've been trying to track down the Sanborn ARs (as well as some others - Reading, Investor's Diversified Services, Disney, Dempster, Crane, Eltra, Blue Chip) but haven't had much luck. Thanks!

Italian securities (bonds and stocks) have always been poor performers. TSR in real terms since - 1965 Equities: 1.3% Bonds: 3.3% 1900 Equities: 1.9% Bonds: (1.2%) Source - https://publications.credit-suisse.com/tasks/render/file/?fileID=AE924F44-E396-A4E5-11E63B09CFE37CCB page 46

Sometimes you get in too deep. She actually seems pretty normal to me. I don't think it's possible to understand her motivations or accurately label her. When I first heard about the case study below, they made it sound like he was a decent guy that needed money for his real business. Eventually, everything spiraled out of control and his intentions shifted dramatically after he came in to BIG money. https://en.wikipedia.org/wiki/John_McNamara_(fraudster) Where Holmes went wrong is she tried to do something very difficult in an industry that is unforgiving. If Holmes plied her craft to an industry like finance where PR charades, deception, and faulty products are the norm, we would probably be looking at the next keynote speaker at Ira Sohn. Even if she did lose her way I have to at least give her credit for dedicating her life to a decent cause and having a goal that is incredibly ambitious.

http://blogs.wsj.com/moneybeat/2016/05/20/read-ajit-jains-memo-about-the-new-ceo-at-berkshires-gen-re/