Two value investors I admire, Bill Ackman (Trades, Portfolio) and Whitney Tilson (Trades, Portfolio), have recommended that to learn about value investing, investors should read Berkshire Hathaway’s (BRK.A, Financial)(BRK.B, Financial) annual letters to shareholders. This series focuses on the main points Warren Buffett (Trades, Portfolio) makes in these letters and my analysis of the lessons learned from them. In this discussion, we go over the 1986 letter.
Buffett and Munger’s two jobs
As portfolio managers of investments intended to be held for the long term, Buffett notes in 1986 that his and Charlie Munger (Trades, Portfolio)’s two main tasks are to first attract and keep outstanding managers and second, handle the allocation of capital.
Managerial stars
Buffett said, “Usually the managers came with the companies we bought, having demonstrated their talents throughout careers that spanned a wide variety of business circumstances” and Berkshire’s “main contribution has been to not get in their way.”
This is obvious and Buffett provides a good analogy:
"If my job were to manage a golf team - and if Jack Nicklaus or Arnold Palmer were willing to play for me - neither would get a lot of directives from me about how to swing."
Managers who are independently wealthy are no problem because they “relish the thrill of outstanding performance” and "find all aspects of their business absorbing.” They “unfailingly think like owners,” which Buffett says is the highest compliment he and Munger could pay a manager.
Buffett says Berkshire subscribes to the philosophy of Ogilvy & Mather’s founding genius, David Ogilvy:
"If each of us hires people who are smaller than we are, we shall become a company of dwarfs. But, if each of us hires people who are bigger than we are, we shall become a company of giants."
This reminds me of some good advice I received from a top portfolio manager I once worked for. He said his goal was to only hire people smarter than people who already worked on his team.
Buffett then wrote something I find quite funny: “When you have able managers of high character running businesses about which they are passionate, you can have a dozen or more reporting to you and still have time for an afternoon nap.” I suspect he does not literally mean they can nap, but rather that they have excellent time management and focus on the big things. The guru warned, however, that it takes just one bad apple to end up “with more than you can handle.”
Most of us are not hiring company CEOs directly like Berkshire, but we hire CEOs and chief financial officers indirectly when we invest in stocks. If we are not convinced by the CEO and the CFO, of their talent and integrity, it does not matter how good the economics look. How can we trust the numbers, how can we trust the strategy and the story? So I think Buffett’s conclusion about hiring outstanding managers and keeping them applies to all long-term value investors because, in a way, value also means stability of the company and credibility of the business.
He wrote:
"We intend to continue our practice of working only with people whom we like and admire. This policy not only maximizes our chances for good results, it also ensures us an extraordinarily good time. On the other hand, working with people who cause your stomach to churn seems much like marrying for money - probably a bad idea under any circumstances, but absolute madness if you are already rich."
Capital allocation
Buffett and Munger’s second job regarding the allocation of capital is different from most companies because Berkshire earns more money than average, retains all that it earns and has operations that require little incremental capital to remain competitive and to grow.
The "Oracle of Omaha" noted:
"If our retained earnings - and those of our major investees, GEICO and Capital Cities/ABC, Inc. - are employed in an unproductive manner, the economics of Berkshire will deteriorate very quickly. In a company adding only, say, 5% to net worth annually, capital-allocation decisions, though still important, will change the company’s economics far more slowly."
Buffett wrote, “Capital allocation at Berkshire was tough work in 1986.” The company made one small business acquisition utilizing only about 2% of Berkshire’s net worth and “had no new ideas in the marketable equities field, an area in which once, only a few years ago, we could readily employ large sums in outstanding businesses at very reasonable prices.” So Berkshire’s main capital allocation move in 1986 was to pay off debt. Of all this, Buffett said, “Neither is a fate worse than death, but they do not inspire us to do handsprings either.”
However, he did show his ability to be patient.
“Markets will change significantly - you can be sure of that and some day we will again get our turn at bat," he said. "However, we haven’t the faintest idea when that might happen.”
This is a good reminder that patience is a virtue when it comes to investing. As value investors, we are not looking for excitement, nor are we looking for much activity. We should just be looking to allocate capital at reasonable prices in companies run by strong management teams.
