Tuesday, May 7, 2013

The 2013 Pilgrimage - Part 1

It is 8:00 pm on Wednesday May 1st, 3 days before the Berkshire Hathaway 2013 Shareholder Meeting. I am at the Atlanta Airport, waiting with great excitement for my flight to Omaha, NE that departs in an hour. This is only my second pilgrimage to Omaha. Last year's meeting was certainly mindbogglingly amazing so I decided to make it an annual event. I found out that there's a Value Investing Conference right before the meeting and many highly admired value investors such as Tom Russo and Howard Marks are speaking at the conference. Therefore, I decided to make this year's trip a little more than just the shareholder meeting.

My flight departed on time. I spent most of the time reading books. " It looks like we are getting some snow tonight at Omaha, ladies and gentlemen." The captain announced about 30 minutes prior to landing. "Great," I thought to myself. "Now this trip is going to be epic. Who would have thought you will get snow in May."

The plane landed a bit earlier than scheduled and I could see the snow outside. It's going to be a wild ride to the hotel. We got out of the plane around 10:30 Central time. Omaha's airport is relatively small and somehow it gives you a very warm feeling. Walking towards baggage claim, I saw a picture of the young Warren Buffett with the words "Invest in Yourself" right next to his picture. He is exactly right and that's why over 35,000 fellow value investors flock to Omaha this year. A six-hour meeting with the "Oracle of Omaha" is one of the best learning opportunities you can ever imagine as a value investor. 

At the end of the hallway is a big screen with a picture of Omaha with the following words: "Welcome, Berkshire Shareholders." Suddenly I felt like I was home and it's awesome. I quickly grabbed my luggage from the carousel and hopped on a taxi right outside the airport. The driver is from Togo and has been living in Omaha for more than 10 years. My taxi driver from last year was also from Africa. I started to think that there is something magical about Omaha that keeps Buffett here.

 I woke up the next day after a sound sleep. It was white outside, like it was still January. I called the taxi driver from last night and he took me to the UNO business school, where the Value Investor Conference is held. I checked in and took a seat in a conference room. First thing I noticed was that there are many people from outside of the U.S, maybe half of the participants are from another continent. Many Spaniards, Aussies, Canadians, South Africans and Brazilians. Robert Miles, the organizer of the conference, gave a brief welcome speech and told a few jokes that ignited a good amount of laugh. Then he introduced the first speaker, Jeff Matthews, author of the internet book "Secret in Plain Sight." It is an interesting book with some very good insights. Jeff opened up with an anecdotal story about how he found out about Dr.Pepper in a small town in Texas then he talked about what he thinks is the most important yet highly ignored secret of Buffett's success- the quality of shareholders. I thought that was a remarkably good point. In the world of investment, during a market crisis such as the recent meltdown from 2007-2009, if you don't have quality investors who shoot for the long run and are less concerned with the near term volatility, you will be doomed by the velocity at which investors withdraw from the fund. When the panic is wide spread, the best way to survive is to have investors who perceive the wide-spread panic as buying opportunities as opposed to the end of world. Yet in the financial world, very often (maybe 90% of the time) money and greed are the drivers of hedge fund or mutual fund managers. If your goal is to get rich fast, you use leverage and you bet big. As we've seen from the collapse of LTCM and other quant funds during the crisis, the ending is often devastating. Investors in those funds had a quick build up of wealth, which evaporated even faster during a so called "25 sigma event". Jeff talked about how his investors stayed with him during the downturn and that made it much easier for the fund to avoid liquidation of loss positions due to withdrawal of funds. 

The second speaker is Ivan Martin-Aranguez, a portfolio manager of the Santander Fund Asset Management from Spain. His topic is "The Case For Spanish Equities." Since most investors will have a home-bias, meaning they only invest in the equity market in the country he or she resides in, it was interesting to hear why the Spanish market can be attractive given different market dynamics such as "less analyst coverage" and " more family-controlled companies." 

The last speaker of the day is Tom Russo, who in his word, is a value investor I highly admire. His topic is " The Capacity to Suffer," which he had presented several times in the past. He shared his favorite story about Charlie Munger. During an interview, someone asked Charlie how he feels about Warren getting all the attention and credit and Charlie said, "well, some people do the talking and some people do the thinking. " This story got a good laugh from the audience. Tom went on to talk about the capacity to suffer. He mentioned that his No.1 question to the management of the companies he invested in is "are you spending enough?" A company can suffer from a prolonged period of paper losses from investing for the long run and Wall Street does not like that but a culture to suffer for the long run is critically important to build a great company. A case in point is Nestle double down on its investment in Russia during the Russian ruble crisis. They built more facilities and made acquisitions when everybody fled Russia because they wanted to avoid booking short term losses in their income statements. Now Nestle is benefiting from a $2 billion a year business in Russia. Another case is Buffett's holding of $50 billion cash before the crisis and willing to suffer short term under-performance when the market shot up. Then when the crisis came, he was able to secure some special arrangement with Goldman Sachs and GE with the cash on hand.  The capacity to suffer is extremely hard mentally, especially when everyone else around you is benefiting from short term gains and you look like an idiot. But the capacity to suffer is also often one of the most important qualities that separate the best from the mediocre. Tom brought out another interesting point, which I have never thought about- margin of safety comes from not only the price you pay, but also from the competitive advantage of the business you invested in. Does P&G offer a good margin of safety at the a seemingly hefty valuation? Yes, and obviously the margin of safety does not come from the price. If it's not the price that gives you the margin of safety, then it must come from the competitive advantage of the business that offers sustainable growth in the future. This is one of the best lessons I learned from the conference. 

After Tom's presentation, Thursday's session came to an end and we were all going to the Omaha Marriott for the CFA dinner which features Mario Gabelli. During the shuttle ride to Marriott, I met an investor from California. He told me he made millions of money during the tech bubble from a few hundred thousand dollars capital and got wiped out after the tech bubble busted. He went in the market and made millions of money again during the housing bubble and got wiped out during the financial crisis. So over the last 15 years his wealth had gone through a roller coaster ride. He went from a middle class worker to a multi-millionaire, and back to a middle class worker and again to a multi-millionaire and then back to where he started. I have not experienced a wild ride like and I cannot imagine what it is like to experience something like that. But his story reaffirmed my belief that not losing money is extremely important in achieving superior returns. This is a big idea that often falls into oblivion in practice. Here is a mathematical illustration: 

Assuming we have investors, Mr. Quantmania and Mr.Valuemania.

Mr. Quantmania started with $10,000 dollars. He leverages up and compounds it for 4 years at 50% per year. In 4 years, his $10,000 will turn into approximately $50,600 pre-tax. That is an admirable achievement on an absolute return basis. Now assuming the market turns into a chaos in year 5, like it did in 2002 and 2008, and Mr.Quantmania suffers a 80% drop in value, his investment now only worth about $10,100 pre-tax at the end of year 5, or approximately 0.2% compounded annually.

Mr.Valuemania also started with $10,000 but he does not use leverage and does not invest in fad stocks. His return is 20% per year for the first 4 years and he loses 20% in year 5. His $10,000 will turn to approximately $16,600 pre-tax at the end of year 5, or approximately 10.6% compounded annually.

There are a few observations we can glean from this imaginary scenario (even though we've seen similar real stories during 2002 and 2008).

1. Mr. Quantmania's cumulative return, prior to the downturn, is 406.25% pre-tax whereas Mr. Valuemania's cumulative return, prior to the downturn is only 107.36%.After the downturn, Mr. Quantamania's return is essentially flat whereas Mr. Valuemania is still up more than 65%.

2. Mr. Quantmania's 80% drop, wiped out almost 100% of his cumulative gains from the 4 years prior to the downturn whereas Mr. Valuemania's 20% loss only reduced his cumulative gains from the 4 years prior to the downturn by 38.6%.

3. Over 90% of investors will choose Mr. Quantmania's fund at the end of year 4 over Mr. Valuemania's fund.

4. Over 90% of money managers will copy Mr. Quantmania's strategy at the end of year 4.

5. A bigger percentage gain is needed to compensate for the same absolute dollar loss. Or inversely, a smaller percentage losses will wipe out a larger cumulative percentage gains, other things equal. Mathematically speaking, a 5% loss will wipe out a 5.26% cumulative gain; a 20% loss will wipe out a 25% cumulative gain; a 30% loss will wipe out a 43% cumulative gain; a 40% loss will wipe out a 67% cumulative gain and a 50% loss will wipe out a 100% cumulative gain. 

6. Knowing implication 5 above, investors should focus on not losing money and if loss of capital is inevitable, limit it to 20% if you can. 

I think I have a better understanding of Mr. Buffett's Rule Number 1 now. It is indeed very simple but not easy. We ended the night with the CFA dinner featuring Mario Gabelli. My biggest take away from the keynote speech is that an investor has got to be able to back up his or her thesis quantitatively, something Mr. Buffett routinely and habitually does and yet vastly ignored by his followers. For example, Mr. Gabelli stated that if you invested in a 5 carat diamond ring 50 years ago, your compounded annual return will be 4.5% whereas if you invested with Mr. Buffett 50 years ago, your compounded annual return will be close to 20%. Now you have an investment thesis backed by quantitative evidence. The best illustration, of course comes from Mr. Buffett.

“I will say this about gold. If you took all the gold in the world, it would roughly make a cube 67 feet on a side…Now for that same cube of gold, it would be worth at today’s market prices about $7 trillion dollars – that’s probably about a third of the value of all the stocks in the United States…For $7 trillion dollars…you could have all the farmland in the United States, you could have about seven Exxon Mobils, and you could have a trillion dollars of walking-around money…And if you offered me the choice of looking at some 67 foot cube of gold and looking at it all day, and you know me touching it and fondling it occasionally…Call me crazy, but I’ll take the farmland and the Exxon Mobils.”

During another interview at a different time, Mr. Buffett said the following

The value of all that gold at today's prices would be about $10 trillion.

As for its merit as an investment, Buffett observes the following:
The cube of gold will produce nothing in the next hundred years (or, for that matter, thousands of years).
The cube of gold will not pay you interest or dividends, and it won't grow earnings.
You can fondle the cube, but it won't respond.

If you had $10 trillion sitting around, Buffett further observes, instead of buying the cube of gold, you could buy all the cropland in America ($400 billion-worth) and 16 Exxon-Mobils. And you would still have $1 trillion of "walking-around money."

Over the next hundred years, your cropland and Exxon-Mobils would produce trillions of dollars of dividends (the size of which would be adjusted for inflation), and you would still have them at the end of the century, at which point you could probably sell them for vastly more than the $9 trillion you bought them for.

So, which investment would you choose?

For the cube of gold to be the smarter investment, Buffett observes, you would have to be convinced that you could persuade someone else that the cube of gold would be an amazing investment at your asking price. Because that's the only way you can ever make money in gold—if there's someone out there who is willing to buy it from you for more than you paid for it (and pay enough to offset the costs you have incurred from storage and insurance in the meantime).

Meanwhile, your cropland and Exxon-Mobils would likely keep throwing off tons of cash even if the market for them completely dried up.

Note that the value of all the gold and the number of Exxon-Mobils you can buy with the value of gold are different as the first interview took place during 2011 and the second interview took place during 2012. Did Mr. Buffett calculate these numbers by himself? Not all of them, at least not the length of the side of the cube that holds all the gold in the world.  You can get that information from websites such as:
  Ditto to the value of all the cropland in America. Mr. Buffett probably remembers it from his readings. However, the secret is, in my opinion, to put the total value of gold into a comparative fashion quantitatively such as the number of Exxon Mobil you can purchase. The underlying thought process centers around opportunity cost. It all boils down to what else you could have invested when allocating capital. "Intelligent people make decisions based on opportunity costs," says Charlie Munger. This is another Mr. Buffett' secret that is often neglected. 

Back to my hotel, I already could not wait for tomorrow.

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