What you will learn from reading University of Berkshire Hathway:
– How financial bubbles form and how they are like a crowded theatre when all goes wrong.
– Key concepts and ideas that Buffet and Munger have talked about over their careers.
– The three overall categories of investment.
University of Berkshire Hathaway Book Summary
This a fantastic introduction and summary of the key concepts and ideas of two amazing investment minds, Warren Buffet and Charlie Munger. I personally love Munger and Buffets skeptical lens they apply to investing and financial markets and how they sift through the bullshit to give time tested investing principles.
This isn’t just a book on investing, it’s a book on business, economics and how to see the world accurately. I particularly like the following quote by Charlier Munger which summaries a lost of their worldview on the current state of the world: “I think if you see the world accurately, it’s bound to be humorous because it’s so ridiculous.”
The creations of Bubbles:
Buffett noted that any asset class that has had a big move will eventually attract speculation. That is now the case with copper and a number of other commodities.
“What could be more exhilarating than to participate in a bull market in which the rewards to owners of businesses become gloriously uncoupled from the plodding performances of the businesses themselves. Unfortunately, however, stocks can’t outperform businesses indefinitely.”
Buffett summed up that speculative markets become like Cinderella at the ball. At midnight, they will turn to pumpkins and mice. Each player wants one more glass of champagne, one more dance, and then they’ll get out in time.
Unlike a crowded theatre where you can just leave your seat and run for the exit, in finance, you must find someone to take your seat. Someone must be on the other side of the transaction. Munger summed up that it will end badly.
On Insider Trading:
While applauding the SEC’s effort to date, Munger observed, “When incredible rewards go to the casino operators, it is extremely unlikely that civilisation has reached nirvana.”
On the Ideal Business:
Buffett: “Something that costs a penny, sells for a dollar and is habit forming.”
On Predicting Business Cycles Buffett:
“If I live X number of years, I’ll go through X number of recessions. But if I spent all my time guessing cycles, Berkshire Hathaway would be $15/share. You can’t dance in and out of businesses based on forecasts.”
How to determine Intrinsic Business Value (IBV):
The Annual Question This is the essence of Buffett’s value approach. Buffett said to determine the IBV of an asset, simply take the present value of the net cash flows from here to eternity, based on current bond rates.
As Buffett has often taught, the intrinsic value of an asset is the cash it will earn from here to eternity, discounted back to the present. However, if your estimated growth rate is greater than your discount rate, you get a value of infinity.
Buffett noted that intrinsic business value can only be calculated in retrospect: cash generated between now and judgment day discounted back to the present at an appropriate interest rate.
What happens when you buy a business:
Buffett also noted that book value is seldom meaningful in analysing the value of a business. Book value simply records what was put into the business.
The key to calculating value is determining what will come out of the business.
Buffett explained that buying a business is much like buying a bond with no maturity and with a blank coupon. You must write in the coupon, and the accuracy of that coupon is the essence of intelligent investing. If you cannot guess the coupon with any accuracy, then do not invest in the business.
The past doesn’t predict the future:
Buffett chimed in, saying that they would have no edge if they tried to evaluate every horse. They have an edge only if they pick their spots. The danger of relying on historical statistics or formulas is that you end up betting on a 14-year-old horse with a great record but is now ready for the glue factory.
Quick Information < Good information:
Asked about the boom in information technology, Buffett replied that his primary information source is the same as it was 40 years ago: annual reports. He emphasised that it is judgment that has utility in measuring price and value. What is needed is not quick information, but good information.
Buffett added that people market these fad theories to justify needing high priests. “If all it takes is the Ten Commandments, it makes it tough on religion. ‘Listen to your customers’ as a business principle does not require a 300-page book.”
On Business Moats:
Munger said the ideal business has a wide and long-lasting moat around a terrific castle with an honest lord. The moat represents a barrier to competition and could be low production costs, a trademark, or an advantage of scale or technology.
Buffett and Munger have repeated year after year that they seek to buy businesses with enduring competitive advantages. This year, they treated listeners to an extended discussion of one key element of a wonderful business: the cost structure. A superior cost structure is often fundamental to a business’ sustainable advantage.
Buffett concluded that you can learn a lot about the durability of the economics of a business by observing price behaviour.
Difference between staying smart being smart once:
Buffett noted it is important to differentiate between a business where you have to be smart once versus one where you have to stay smart. For example, in retail, you are under assault at all times versus a newspaper, where you just need to be first.
On stocks trading for 100x their revenues:
Especially with Internet stocks trading at 100 times revenues! Our favourite comment from this year’s Berkshire annual meeting: When asked how he would teach business students, Buffett said, “For the final exam, I would take an Internet company and say ‘How much is this worth?’ And anybody that gave me an answer, I would flunk.”
The Impact of the Internet on Stocks:
What the Internet really did, asserted Buffett, is give promoters the chance to monetise the hopes and greed of millions of investors through venture capital markets. A lot of money transferred from the gullible to the promoters. Very little real wealth has been created.
Buffett asserted that the biggest money made in Wall Street in recent years has not been made by great performance, but by great promotion. Munger claimed the current scene is “obscene,” with too much misleading sales material and television emphasis on speculation.
Using Insurance Floats:
Berkshire vastly prefers businesses where you get the cash up front (like insurance).
The value of float is powerful leverage. As Munger put it, “Basically, we’re a hedgehog that knows one big thing. If you generate float at 3% per annum and buy businesses that earn 13% per annum with the proceeds of that float, we have figured out that’s a pretty good position to be in.”
In a similar vein, Munger noted that the fraud group percentage is high for those who talk “EBIDTA.”
Professor Buffett continued that the “D” (depreciation) not only reflects a real cost, but the worst kind of cost. Depreciation reflects cash that is spent first, and the deductions only come later.
Similarly the “T” (taxes) is a real cost. To pretend otherwise is delusional.
Try to understand what’s going on:
Munger shared that it helps to have a passionate interest in knowing why things are happening. That cast of mind over a long time, he asserted, will improve its ability to cope with reality. Those that don’t ask why are destined for failure, even those with very high IQs.
Options issued as compensation can work if there is 1) a cost of capital associated with them, and 2) the issuance is tied directly to performance.
In the 1990s, they served as the conduit for a major wealth transfer from shareholders to employees. Boards awarded options as if they were handing out candy. Consultants promoted option issuances as if it were play money. CEOs looking to juice earnings were pleased to issue options as they were not treated as an expense. Employees enjoyed the free lottery tickets.
Good Compensation Buffett allowed that managers can make a lot of money at Berkshire, but the bonuses are always related to performance. For a good compensation agreement, he advised, you must understand the keys to the business and keep it simple.
Munger asserted that all intelligent people base decisions on opportunity costs. The alternative returns available should weigh on whether you make a particular investment. It is freshman economics.
Stocks to avoid during Inflation:
The worst sorts of businesses to own in an inflationary environment are ones that require lots of capital to stay in the game and provide no real return.
Correlations and consequences:
Munger noted the common error is not thinking through the consequences of the consequences. Buffett reflected that lots of things correlate that people don’t expect to correlate.
Buffett warned that when there is trouble, everything correlates. Thus, in managing catastrophic losses, one must think through the ripple effects.
Learn from History:
Buffett claimed that successful investing requires not extraordinary intellect but extraordinary discipline. Few have it. In fact, he mused, “What we learn from history is that people do not learn from history.”
Buffett also noted that the government bailed out GM, so how could it not also come to the aid of a troubled state? The problem is a moral hazard: if the undisciplined are not punished for it, then why should others be disciplined?
Errors of Omission
Buffett noted that not maximising the rare good idea has cost shareholders more than his sins of omission. Though sins of omission do not hit the financial reports, Munger said that they still rub their noses in it.
He noted that in long tail insurance, the numbers can be pretty much whatever you want them to be. Berkshire’s $45 billion in loss reserves could just as easily be $44.75 billion – especially if he wanted to report $250 million more in earnings. Buffett opined that the worldwide tendency is for management to understate reserves.
Buffett believes that real risk comes from the nature of certain kinds of businesses, by the simple economics of the business and from not knowing what you’re doing. If you understand the economics and you know the people, then you’re not taking much risk.
Buffett noted, “Envy is the worst of the seven deadly sins. It’s the only one that makes you feel worse, and the other party feels nothing. Gluttony – that has at least some temporary upside. As for lust – I’ll let Charlie speak to that.”
The Key to Investing in the Market:
The key with markets is that you cannot allow yourself to be forced to sell (from using too much leverage) and that you must not sell in a panic mode, emotionally pulling the rug out from under yourself.
Bonds Vs Equities:
Buffett noted that the analytical hurdle for buying a bond requires answering the question, “Will the company go out of business?” while buying an equity requires answering the more difficult question, “Will the company prosper?”
Then he outlined three categories of investment:
Category 1 – Investments denominated in a currency.
Buffett pulled out his wallet, took out a one dollar bill and read out loud, “In God We Trust.” He noted this is false advertising. What it should say is, “In Government We Trust.” God isn’t going to do anything about that dollar. The point is that any currency investment is a bet on how government will behave. Almost all currencies have declined over time. Unless you get paid really well, these investments don’t make much sense.
Category 2 – Investments that don’t produce anything but you hope to sell at a higher price. Gold, for example.
Category 3 – Investments in assets that produce something. This is a play on what you think that asset will produce over time.
Capital Allocation and sound wealth building:
Allocation of capital is the key to future returns in the business world.
There are essentially five things public corporations can do with a dollar earned: reinvest in the business, acquire other businesses or assets, pay down debt, pay dividends, and/or buy in shares.
Deciding how much to allocate to each of these five areas ideally is driven by “opportunity cost.” In other words, each extra dollar should go where it gets the best risk-adjusted return over the long run compared to all other competing opportunities.
Intelligent capital allocation is the essence of sound wealth-building.
In an effort to improve public discourse, Munger weighed in with Munger’s Law: You can’t list the detriments without listings the benefits.
Munger suggested it would be like cancelling air travel because 100 people died in a crash. Buffett likes peanut brittle and flavoured drinks. People should be free to choose to do what they like.
Micro before Macro:
Get the Details Asked how he does it, Buffett shared that he and Charlie read a lot. What matters most to him are micro factors, as opposed to the macro factors that so often get all the attention. He loves to know all the details of a business.
Each business will have a couple of unique factors that are essential in evaluating its progress. Often, those unique factors are not immediately reflected in the reported earnings. In our short-attention-span world, analysts and the media so often focus on reported earnings and look no deeper.
Quality of the Business + Quality of the People Buffett said what matters most with an acquisition is whether you have a fix on the basic economics of the business.
He argued that typical due diligence does not get at the real risks. He could think of at least a half-dozen mistakes made, none of which could have been prevented by a checklist. It’s all about the future economics. For example, if you give a manager $1 billion for a business he once owned 100%, will he behave in the future as he has in the past? It’s a hugely important question that’s not on a checklist.
Self selecting culture:
In a response to misdeeds at Wells Fargo, Buffett noted that Berkshire benefits from decentralisation. However, with hundreds of thousands of employees, there is no question that, somewhere, a few are behaving inappropriately. Berkshire leans heavily on principles of behaviour rather than loads of rules.
He claimed that a culture that self-selects is better than a 1,000-page manual. Buffett sends a letter every other year to all the managers with the “Salomon pledge”: “Lose money for the firm and I will be understanding. Lose one shred of reputation for the firm and I will be ruthless.”