In 1982, working as a 26-year-old money manager, I passed on Berkshire Hathaway, which was trading at $97, because I thought it was too expensive. The price represented a 50 percent price to earnings and price to book premium to the broad market. Had I made a different decision – at the time I was sitting on a large cash position from a successful real estate investment – I would now be smoking $10 cigars and hanging out with swell chicks. I’ll wait, I thought, until it hits $60. I’m still waiting. On Friday BRK.A closed at $217,000.
Although I was familiar with Warren Buffett’s investment record – he was widely regarded as one of the best investors of his generation, and I carefully read the Berkshire Hathaway annual report each year – he had not attained the prominence he now has. I mentioned this to Ian, and he suggested I might write about what I learned from passing on Berkshire Hathaway, and the years I worked as an investment analyst on Wall Street.
By way of background, I did not finish high school. I left home at the age of fifteen and hitchhiked up into Canada’s subarctic and worked fighting forest fires and then as a forest tower lookout. The loneliness was too much for me, so at the age of eighteen I became a real estate salesman. In my early twenties I sold hotels and nursing homes, and then met with some success as a real estate investor. I became fascinated by the stock market, and a full time investor in my mid-twenties. Within a couple of years I was managing money, specializing in mismanaged, undervalued companies. They ran the gamut from companies whose stock had declined significantly, had new management, heavy insider buying, to the bonds of bankrupt or distressed companies, to companies with substantial real estate holdings, low insider ownership and minimal or no profitability. I was fairly successful at this in Toronto, acquired some major clients in New York City and in my late twenties moved to the US and started an investment research firm serving institutional money managers and corporate acquirers. I did that for five years, made some money and retired to the Adirondack woods.
Overall, I was successful but my performance was extremely volatile including two years in a row down over 40 percent. Most of my investments lost money or broke even; the few winners were up so much that overall my portfolio averaged a thirty percent return. Among my clients were some of the most successful corporate acquirers of the day – Sam Zell, Richard Rainwater, Leucadia, Jay Jordan, and some of the most successful money managers of the day, Chuck Royce, Leon Levy, Michael Price, Seth Klarman, Fidelity’s Alan Leifer, Ernie Kiehne of Legg Mason (Bill Miller was Ernie’s assistant at the time), George Soros — about 100 money mangers paid my firm $20,000 a year in soft dollars for my “contrarian research.” They followed my work because I studied, in an in-depth way, companies not otherwise followed by analysts.
Much of what I learned I learned from watching extremely successful investors make and lose money. And from losing my own money.
What did I learn?
Lesson 1: The role of financial markets is to take money away from mediocre and underperforming companies and put it in stable, growing, high return on capital companies. Money has an almost metaphysical attraction to places where it is put to careful, good use. You can fight that trend, and invest in companies, for instance that are deeply undervalued and mismanaged – and some people are successful investing in the dregs – but very few over the long term. To use a whitewater kayaking analogy, freshwater seeks salt water, and you can fight that if you want, but paddling upstream eventually is likely to become highly problematic.
The approach that’s worked best in my experience is investing in high return on capital, low debt, growing companies that have the ability to reinvest earnings in the business and generate high returns on those reinvested earnings. The power of compound interest is so profound (mind-boggling really) that over time, returns in investments in those companies are enormous. The trick is finding companies that are compound interest machines. I remember Leon Levy, founder of Odyssey Partners, once telling me that John Paul Getty became the wealthiest man in the world by achieving a 17%percent compound rate of return, on average, over his career.
As in the case of Berkshire Hathaway, trying to invest in those companies based on an analysis of value is more likely to result in opportunities missed than it is make money. An approach that is much more likely to be successful – investing in high quality companies after a market decline of thirty percent, and retaining the liquidity to build positions in those companies after a fifty percent decline in the broad market averages. That takes extraordinary patience, which is a matter of personality.
Lesson 2: I’ve worked for two extremely successful investors who were experts in cyclical, commodity-dependent, capital intensive industries – real estate and mining – and learned that almost all of the real money made in those areas is made only by extremely patient investors who invest once every ten or twenty years, liquidate their holdings once a decade and spend long, long periods of time in cash.
One of those investors, Pat Sheridan, an owner of mines all over the world, once said to me that the classic business mistake was to be fully invested at the top of the market. The objective, he said, was to be liquid at the bottom because business cycles are primarily caused by the creation and destruction of debt. Those are functions of greed and fear, in other words of emotions. He built inventory (by buying mines) during times of low demand, and sold them during times of high demand, including one for $10 million in 2011. Managing cash is crucial to his strategy, he told me.
When oil or real estate prices increase, money flows in to take advantage of what appears to be above-average returns. Overcapacity results, prices decline, debt can’t be serviced and gets converted into equity or otherwise written off, capacity declines and within a few years commodity prices begin to recover. Then the whole cycle starts over again. The swings are unpredictable in terms of duration, but successful investors in those areas look for opportunities after a major (20 percent or more) capacity reduction in an industry, when the debt of the bottom thirty percent of companies in terms of quality of management and assets no longer exists and the debt of mediocre companies (the next ten or twenty percent of companies) trades at pennies on the dollar.
Three approaches, I’ve observed, work best over time: investing in the low cost producer with a durable cost advantage, investing in premium assets such as well-located real estate, and buying debt at pennies on the dollar after an industry wide collapse. All three strategies are most successful after a severe market decline when emotionally it is difficult to do.
The approach that almost always results in disaster – investing in cyclical stocks based on P/E ratios. Cyclical stocks are cheapest when, industry-wide, companies are losing money or have very low earnings, and most risky when they have low P/E and high price-to-book ratios.
Lesson 3: Most successful investors share some common personality characteristics.
They have superior analytical skills in at least one important area of investing. This results from an obsession with investing. They are students of the art. Ian, your commentary on this subject has helped me really focus on what I think I do better than most other investors. In your case Ian, I think that you have an important long term advantage in being willing to, and knowing how to, build relationships with management based on mutual trust and respect. In my case it is an ability to identify superior companies based on financial statement trends. I think. I hope. Only time will tell.
My skill evolved out of the realization that I could have avoided 90 percent of my disasters by spending a couple of hours with a company’s quarterly balance sheets and income statements. Instead, I would routinely fly thousands of miles, interview management, interview former executives and directors, especially those bearing grudges, visit company real estate and local appraisers, interview competitors, suppliers, and customers. I even, on occasion, would sit in a bar outside company factories and have a beer (or two) with workers coming off shifts. I studied accounting at night, read Ben Graham’s classic Security Analysis (twice) and spent twenty years running a business with customers, distributors, suppliers, employees and, as part of that, prepared financial statements once a month. I learned what fluctuations in twenty criteria including inventory, accounts payable and receivables and gross profit margin indicate about a company’s competitive position and prospects. That makes me uniquely qualified, I think, to analyze companies based on their financial statements. We’ll see.
Investing can be looked at as an emotional competition – your emotions and ability to control them versus the emotions of those you buy or sell securities from and to. A primary function of investment strategy is to counteract emotional impulses and thus survive (and take advantage of) adverse market developments. Investment performance is mostly determined by patience, risk management, a willingness to study, and what you do when things go differently than you anticipated. Those factors are personality driven.
In addition to having a clear concept of what their competitive advantage is over others, successful investors, I’ve learned, incorporate into their investment strategy clear concepts of acceptable risk, what constitutes an acceptable level of inactivity and length of holding period after funds are committed. And successful investors stick to their strategy. That strategy – for instance sitting on cash, sitting on losing positions, sitting on winning positions — must be based on self-knowledge. If the strategy is out of sync with the personality, it won’t work, no matter how well it has worked for others.
There are successful short and long term investors, but rarely are there successful investors who do both. A long-term investor must be a patient person. A short term trader who thrives on, perhaps needs, constant activity is likely to be an impatient person.
Regardless of short or long term investor/trader, risk management is crucial to survival and success. Once again, this is a personality issue. A successful investor’s strategy will anticipate adverse market developments – will assume that sooner or later they will be wrong and will lose money. Cash position versus invested capital is perhaps the single most important area of risk management, although acceptable debt levels (both in one’s own financial structure, and the companies in one’s portfolio) is also important. Does an investor have a cash management plan that fits with the other key elements of his or her investment strategy? Successful investors, in my experience, think their cash position through very, very carefully and they pursue a strategy that mitigates risk in what is otherwise a very risky field of endeavor – investing. Depending on the stage of the market cycle, very high or very low cash positions have a major impact on portfolio returns. And on investment survival.
Does and investor buy on strength or buy on weakness? Fluctuations in security prices are often determined by factors other than the underlying fundamentals of the companies involved. A stock can decline due to a major investor needing to raise cash, emotion, faulty analysis, and macro economic factors that do not affect the particular company in question. Is an investor a victim of those factors or a beneficiary? Does an investor know more about a particular company than the market? If yes, buying on weakness augments an investor’s returns. If not, returns are diminished by buying on weakness. Does an investor have the ability to admit when he or she is wrong and take action? Does an investor have the courage to buy during irrational price declines, when economic collapse is widely anticipated and discussed in the news media? Those factors impact long term returns, and they too are personality driven.
Ian, I find your belief that quality companies with market caps of under $30 million are more or less immune to general market declines because they have low institutional ownership very intriguing. Regardless, I strongly suspect that investing in quality companies that used to have market caps of over $100 million, and high institutional ownership, but now have market caps of under $30 million and no institutional ownership because the market is down 50%percent, is a lower risk variant on your strategy.
Whatever one’s position on that subject, an investment strategy needs to anticipate significant market declines, as well as declines in the securities in one’s portfolio, since declines have been a part of markets ever since markets were first created. Humans are emotional, therefore markets are emotional, debt results, markets collapse, and humans become more emotional. And master investors invest.
Or something like that.
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Great article Rod. You have a great background.
” I did that for five years, made some money and retired to the Adirondack woods.”
What helped you decide to retire after having a successful research firm for 5 years?
I was burned out. I didn’t fit in on Wall Street. I wanted to do something more positive with my life, and live among green and birdsong.
Wall Street is a rough, tough place. As a multi-millionaire said to me after he did me out of $3000 in commissions — “I made my money $3000 at a time. Welcome to the National Football League.” Or something like that.
When I arrived on Wall Street, I think I conducted myself at a standard of integrity roughly on par with that of my peers — ie not very high — but as the years went on I came to see the value of honesty in living a good life, a quality life, as crucial. By the end I was working mostly for greenmailers, who if greenmail failed would take over companies and fire a very substantial portion of the people who worked there. There is an impact on lives from that process that is very negative, including divorce and suicide. An argument can be made that sooner or later many of those companies would have needed to downsize anyway because they were mismanaged, but the buyers of those companies, the people I worked for, were great at slashing, but generally not that great managers themselves.
I felt like I was sinking into a morass.
On the other hand, I worked for some particularly charismatic, brilliant, insightful entrepreneurs and investors, and I not only learned a lot, but enjoyed some exhilarating times. It was a lot of fun at first but over time became a drag.
Rod where in the Adirondacks are you located? Im in Queensbury.
Sean, people that live in the Adirondack woods are there because they don’t want others to know where they are 🙂
Is that why Im here? Ok , I just presume he was eaten by the bears lol
Sorry didn’t see your question until now. Will check off “Notify me…”
I’m in the Split Rock Wildway near Essex NY.
I really enjoyed reading this article Rod. In a future article, or in these comments, I would love to hear about any more stories/lessons learned you’d be willing to share from the entrepreneurs/investors that you reference here (other than Pat Sheridan and Leon Levy):
“I worked for some particularly charismatic, brilliant, insightful entrepreneurs and investors, and I not only learned a lot, but enjoyed some exhilarating times.”
Thanks for sharing,
Thank you for your response but am involved in many projects, and lack time to write more for now. To the extent I have time I want to use it for writing about specific nanocap stocks that seem interesting for this group. I hope to get to that in the next two weeks.
But I look forward to sharing stories when our trails cross, perhaps at a Microcap investor get together.
Thanks Rod. Looking forward to sharing stories when our paths cross, hopefully sooner than later.
Well written article! Is there a reason that you never reevaluated your pass on Berkshire? There have been a few times that the stock has fallen dramatically for a while since 1982.
I was out of the market for most of the 30 years since I left Wall Street, and focused on publishing, mostly my own art and writing, but also the republishing of out of print wilderness classics, with a side interest in rental apartments.
Since I have returned to the market, I’ve been focused on much smaller companies.
But your question makes me wonder, in case you know, during those dramatic market declines, did the stock trade at mulitples of earnings and book value approximating those of the general market?
Hi Rod, just wanted to say I thought this was well-written. Am going to track your posts from now on, even if sporadic as you say 😉
Thank you Rommel
Great article! How would you advise investors to help them come to terms with the idea of market timing when they hear others, including Buffett, saying to stay 100% invested?
I am not aware of Buffett having said that, but I would be EXTREMELY surprised if Buffett was 100% invested in equities, for lots of different reasons. In his 2008 annual report, Buffett wrote:
“I have pledged – to you, the rating agencies and myself – to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits.”
And somewhere else I read of his saying, “I don’t borrow money because if you are smart you don’t need to, and if you’re not, it won’t help.” Or something like that.
Strategically, I think a lot depends on what other investments and cash flow an investor or speculator has. If 90% of one’s portfolio, for instance, is in real estate, having the remaining 10% fully invested in common stocks is probably different than having 10% of one’s portfolio in real estate and 90% fully committed to common stocks. But regardless, I think some cash position is always good just for contingencies. Buffett invested five billion dollars in Goldman Sachs, GE, etc in 2008 because of planning, not accident, I’d suggest.
In my experience, highly successful investors and entrepreneurs carefully think through these subjects: risk profile, their past history of success and failure and create a plan that incorporates what skill or practice they have that gives them an advantage over other investors, cash position, as well as their average holding period, and all those factors work together based on that plan, and that plan fits their personality.
In my case, I have an inclination toward short selling and being negative on the market — a bias that has cost me a LOT of money over the years — as well as a poor record in assessing management skill, so I’ve tried to develop a strategy that is not reliant on predicting the market and that invests in top quality companies based solely on their financial results (little or no debt, return on capital, return on capital trend) as opposed to my impression of management. And I scale my cash position not on what I think the market is going to do — because I’m wrong most of the time — but on what it has done over the last few months.
My strategy works for me I think because it is based on an indepth study of my many failures.
Thanks Rod. That was brutally honest confession.
On your criteria or choosing a stock – have a very similar one for myself.
Great article Rod. Knowing what you know now, would you invest in the next Warren Buffett today or would it not pass your personal filters?
That is a surprisingly difficult question. I’ve usually got an answer for everything, often wrong of course, but on this one I just don’t know. Knowing what I know now, would I invest in a consortium of controlling and non-controlling interests in companies put together but a young(er) man with a great track record who offers a clear logic behind his investments?
Probably not, for two reasons:
1. I’m very concerned about this market. I don’t what is going on, although I do suspect it is related to the strong US dollar and how integrated the US economy is now with the rest of the world. We have 4.5% of the world’s population, and have about 60% market share in all of the high margin industries — pharmaceuticals, music, movies, technology, military hardware and software, etc. There is something very strange going on out there. I think it might be related to foreign economies, particularly the international banking system, based on the US dollar — lending dollars with the expectation that revenues based on other currencies will service that US dollar debt. I’m now 90% short, even though on balance I’ve lost money shorting stocks and markets, and done quite well, on average (though volatile) long.
2. The long position possibilities that I study and think about are all very small cap companies that dominate some niche, or have a clear competitive advantage in a larger niche — either through exceptional quality/premium price or cost advantage. Those are the kinds of companies that Berkshire Hathaway invests in — Buffet doesn’t typically take positions in holding or investment companies — but that is not BRK.A itself.
Buffett says he likes to take positions in companies that are easy to understand. Berkshire, particularly with its insurance company investments, is not easy to understand.
Hey Rod!! Are you on twitter?