The Buffett Blog

At the end of 2006, one of the most talked-about streaks in value investing (heck, in any kind of investing) came to an end. Bill Miller's Legg Mason Value Trust failed to outperform the S&P 500 Index for the first calendar year since he took over sole management of the fund in 1990. Rumours about the end of the streak led to a lot of publicity and commentary and only added fuel to the fire when the firm announced in late October that they expected 2Q 2007 net income to come in below analyst estimates.

In the letter, Miller acknowledges the streak right up front. Making use of both a priori and a posteriori probabilities, he demonstrates the odds that one could replicate his success. Needless to say, "there was probably some skill involved". That said, he doesn't allow himself to be satisfied with having done something that most probably could not, and in doing so, demonstrates the kind of character that is difficult to find in an industry where "just getting by" still compensates you pretty darn well.

Active managers are paid to add value over what can be earned at a low cost from passive investing ... We are paid to a do a job and we didn't do it this year, which is what the end of the streak means, and I am not at all happy or relieved about that.

The remainder of the commentary is spent on reviewing Miller's investment principles and singling out a few of the reasons why the streak lasted as long as it did. Two sources of outperformance for those 15 years that he finds applicable to investing in general: valuation and portfolio construction.

On valuation:

Valuation is inherently uncertain, since it involves the future. As I often remind our analysts, 100% of the information you have about a company represents the past, and 100% of the value depends on the future

And on portfolio construction:

We construct our portfolios the way theory says one should, which is different from the way many, if not most construct their portfolios ... We want our clients and shareholders to own a portfolio actively chosen based on long-term value, not based on index concentration.

He touches on other topics that helped the outperformance, such as factor diversification and concentration, and on being willing to take advantage of errors made by others, due to social psychological cognitive errors (read: behavioural finance).

It is trying to invest long-term in a short-term world, and being contrarian when conformity is more comfortable, and being willing to court controversy and be wrong, that has helped us outperform.

Miller's letters are always a treat, but this one serves both as a nice summary of his thoughts on investing to date, as well as an example of the type of humility that true investors always possess, even if their results do have odds of 1 in 2.3 million.

eta: actually putting a link to the letter in the post would probably help. it can be found here [warning: .pdf]

As we mentioned in our most recent post, the start of the new year is prime time for making New Year's Resolutions. It also happens to be prime time for investment managers' fourth quarter commentaries.

We'll start with Ron Muhlenkamp of Muhlenkamp & Company, whose letter focuses primarily on expecations for the economy and market in 2007. Muhlenkamp is looking for a soft-landing until the spring, when he sees the onset of an economic expansion. Even better than the letter is the attached Q&A from a November investment seminar that goes through what the firm looks for in its holdings; discusses its views for the homebuilding, technology, and pharmaceutical industries; and touches on the hot-button issues of outsourcing and executive compensation.

What I have learned over the years is that if you have good companies at good values, sooner or later, somebody will come along and buy you out ... whatever method buys us out doesn't matter. As long as we've got good companies at cheap prices, sooner or later, someone will bid up the price.

Next, the folks over at Tilson who attribute a good portion of the performance in their Focus Fund to avoiding losses, emphasizing that "It is our nature to focus on playing defense by only investing in situations in which we think the risk of permanent capital loss is very limited". They also touch on their selling philosophy, outlining the four factors that they weigh when deciding to exit a position:

1) If a stock has risen to intrinsic value.
2) If they find a better investment.
3) If the story changes materially in a negative way.
4) To balance their portfolio.

Good ideas to keep in mind, especially since so much of the literature and efforts are often focused on stock picking and buying, without considering that exiting at the right time is just as important, if not more so.

The gents at Tweedy, Browne comment at length on the world's position "awash in a sea of liquidity" which has stimulated demand, driven up asset prices, reduced volatility, and sent risk premiums into the ground. Their opinion? It's not time to buy now - they are remaining cautious.

In general, as value investors, we tend to add the most value when we are being well compensated for the risks we are bearing. This is not one of those times ... bargains still remain scarce.

Backing up Tweedy, Browne's claim is Wally Weitz at Weitz Funds, whose letter starts with thoughts on the "changing changelessness" of human nature, pointing out that regardless of what happens in the world, "short-term thinking leads to alternating bouts of fear and greed". He then goes on to look to buying opportunities going forward which are, in his opinion, not very good.

So, what next? There have only been a few times when stocks were so cheap that good returns seems assured - and those times were so scary that it was not clear that stocks would not fall a lot more before finally doing well. Stocks in general don't seem particularly cheap today.

Oh, those value investors. It's just optimism around every corner with them!

Happy new year to all our readers. Where did the time go? Nearly a month into 2007 and no news on our front - apologies all around. Here's our New Year's Resolution - a more frequent posting schedule. Let's see how long we can keep it going.

First up, Warren Buffett wasn't going to let 2006 go off gently into that good night. In late December, Berkshire Hathaway purchased TTI Inc., one of the world's largest distributors of passive and electromechanical components. As usual, the founder and current chairman and CEO, Paul Andrews, will remain in charge. Also as usual, the company's line of business is fascinating stuff - trimmers, wire and cable, electromechanical devices (oh my).

Regarding year-end lists, Buffett managed to secure a position on Forbes' list of the world's billionaires, clocking in at number 2. Of course, we couldn't manage to find a year-end list of "world's most awesomely giant donations to charity". If so, the Oracle would easily take first place, after his well-publicized gift earlier this year.

And last, what better way to start the new year than by revisiting some of the best lessons of the past? In a recent Forbes piece, the magazine sits down for Q&A with Mary Buffett, who was married to Warren's son Peter for 12 years. Mary has written or co-written several books on the Oracle, and the latest, The Tao of Warren Buffett, attempts to collect some of WEB's best advice in 125 quotes. Most of us already have a good number of Buffett-related books on our shelves and may not need another, but the article's worth a look, if only for the slide show of WEB's "Wisdom in Words".

A few years ago, Michael Lewis, famed author of the classic Liar's Poker, put out another great book, Moneyball, that has since inhabited that odd space where sports, investing, statistics, and leadership collide. Lewis is back at it again, out on the PR stump for his newest book, The Blind Side, that covers undervalued players in football.

From a recent interview with Fortune, a few quotes that are highly applicable to the search for value, whether that comes in the form of a stock that's getting beat up by the Street, a catcher with a great eye for the strike zone that scouts think is past his prime, or a poor kid from the innner city who manages to make it big in the NFL.

On Billy Beane and how he manages to still outperform, even though his "value" approach is common knowledge:

He is still measuring baseball players' value more precisely than other people and buying the ones where the market price was cheaper than their true value ... He has a real ability, like a really gifted trader, to act on his own judgments. This is painful for most people to do, because they face ridicule and ostracism. I think intelligence is overrated as a quality central to this kind of innovation. It's a kind of nerve. It's the ability to take a risk.

And on achievement and creativity:

Nevertheless, the evaluation you do of yourself has to be independent of the world's evaluation of you. The pressure's always going to be to draw you back into doing things the way everybody else does them. Doing things differently is inherently threatening to people because if it works, it's damning of the way they've been doing things.

Sound familiar? It should. Good ideas never go out of style.

"Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it - even though others may hesitate or differ". (You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.)
- Benjamin Graham, The Intelligent Investor

Bill Miller's latest commentary came out last week, peppered with the usual references to philosophers from the 19th century and, of course, references to our friends WEB and Charlie Munger.

Fun on price and value:

Since more things can happen than will happen, if we can identify where our expectations differ materially from those embedded in market prices, we can construct portfolios that we believe will earn higher risk-adjusted rates of return over time than could be earned by a passive investment program.

This involves always keeping in mind a basic business principle: only compete where you have a competitive advantage. Warren Buffett refers to staying within your circle of competence.

And on the ways to make money in the markets, with a bonus shout-out to behavioral finance:

In markets, competitive advantages are three: informational, analytical, or behavioral. Informational advantage is when you know something material that someone else doesn't. It is the easiest to exploit and the hardest to find ... Analytical advantages come from taking publicly available information and processing or weighting it differently from the others ...

Behavioral advantages are the most interesting because they are the most durable. The field of behavioral finance is still in its infancy yet has already yielded results that can be incorporated profitably into a sound investment process. The best part is that such results are likely to be systematically exploitable and not able to be arbitraged away as they become more widely known. That is because they represent broad findings about how large groups of people are likely to behave under well-defined circumstances. Until large numbers of people are able to alter their psychology (don't hold your breath), there is money to be made from prospect theory, support theory, cognitive psychology, and neuroscience.

Miller's key point: ask yourself why you think the way you do. Question your assumptions, but also your own mindset and temperament. Examine the glasses through which you see the world - you might be surprised that the glasses, not the world, are what's affecting the view.

Though there has been tumbleweed blowin' through these here parts the last few months, rest assured that we are still here, and still trying to keep up with the Oracle and his every move. Of course, dear WEB hasn't made this easy for those of us on summer internships, with his gift heard round the world.

The press coverage on the gift, on Warren, on the implications of this gift for future philanthropic actions, and everything else under the sun has been enormous. Nevermind the catching up to do on WEB's other charity work this spring, any activity at Berkshire, and news on value investing at large. We'll do our best to catalogue it all at some point.

For now, we'll leave you with the Fortune cover story, an interview between WEB and longtime friend, Carol Loomis.

Unless, of course, you're into Buffett. Amidst the buildup to "Woodstock for Capitalists", Buffett and Berkshire were heavily featured in the popular press, with admiration and doubt being administered in equal measure.

In early April, in what may have seemed like an out-of-character move, Buffett made a substanial $14B bet on the global stock market by selling long-duration equity index puts. Given that he's referred to derivatives as "financial weapons of mass destruction" in his 2003 Berkshire letter it may seem incongruous that he'd take such a large position. However, the contracts are structured in such a way that,

For Berkshire to lose the $14 billion that the company says is at risk, all four indexes covered by the puts would have to fall to zero, according to Gary Gastineau, managing director of ETF Consultants LLC, a research firm in Summit, New Jersey. That's unlikely given historical trends.

And, let's not forget that Buffett has had success with derivatives in the past. Witness the opposite bet made on the S&P 500 in 2002 that netted $60M, or the bets on the widening U.S. trade deficit that has since brought in $2B in investment gains. Let's face it - what are selling puts, except another form of aggregating float? Collect income now and invest it in the interim. This is a concept with which Buffett is intimately familiar.

And what to do with this cash? Buy a sportswear company, that's what. In mid-April, Russell Corp. agreed to be acquired by Berkshire Hathaway for nearly $600M, adding to Berkshire's existing apparel holdings. And on May 5th, Buffett's entry into the exciting world of metal-working, with his $5B purchase of Israeli firm Iscar (not to be confused with the universally bad idea, Ishtar). The Iscar deal demonstrates another classic Buffett move - buy a family-owned company and then leave them the heck alone.

Different takes on Buffett cropping up post-Letter, pre-Woodstock.

Point: Jon Markman calling for the Oracle of Omaha to be renamed the Natterer of Nebraska, based on recent flat performance by Berkshire.

Surely there was a time when Warren Buffett was a chief executive worth studying, and even investing alongside. But it sure seems like that time is long past...

And the counterpoint? A defense of the Oracle by Jim Jubak, who, in addition to providing a nice summary of the logic behind Buffett's insurance holdings, rightfully points out that

Deciding whether Buffett is the greatest living investor may be an interesting parlor game, but it has nothing to do with whether or not you should own Berkshire Hathaway stock right now.

As always with a stock, it's not how the stock has done in the past that counts but how it's likely to perform in the future. Yes, Berkshire Hathaway's performance in 2004 (a 4.3% return) and 2005 (flat for the year) was pretty lame. But I think you want to own Berkshire Hathaway now precisely because 2004 and 2005 have positioned the shares very nicely for solid profits in 2006.

All of the opinions aside, it's Woodstock down in Omaha this weekend, and the topics on everyone's mind are succession and acquisitions. What's next for Berkshire? What to do with all the cash? Names being tossed into the mix include: Harley-Davidson, Mattel Inc., PG&E, Mercury General Corp., and more.

And last, to prove that Mr. Buffett isn't all business, a few items for fun. First off, Buffett will be involved in a children's animated series entitled "The Secret Millionaires Club" designed to teach the youngsters all about investing. Second, if anyone has a burning desire to buy a Buffett-owned musical instrument, the ability to do so is only a click away. Buffett is auctioning off an autographed ukelele on eBay later this month, with proceeds going to the Omaha Children's Hospital. Click through to the article, folks. The picture alone is worth the price of admission.