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The Science of Hitting
The Science of Hitting
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Berkshire Hathaway Meeting: 1996 Afternoon Session

Highlights from a past annual meeting

June 15, 2020 | About:

In 2018, CNBC launched the Warren Buffett (Trades, Portfolio) Archive, “the digital home to the world’s largest video collection of Warren Buffett (Trades, Portfolio).” The website includes complete video footage from every Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) shareholder meeting since 1994, in addition to video clips from Buffett’s appearances on CNBC dating back to 2005.

As discussed previously, my goal in this series is to share key takeaways from each shareholder meeting. I will select a handful of quotes from each section that I think are most insightful and thought provoking for investors. With that, let’s take a look at the 1996 afternoon session.

Great businesses

At the beginning of the session, Buffett was asked about the characteristics he looks for in a great business, along with the role that management plays in that determination. Here was his answer:

The really great business is one that doesn’t require good management. That is a terrific business. And the poor business is one that can only succeed, or even survive, with great management. We look for people that know their businesses, love their businesses, love their shareholders, want to treat them as partners. We still look to the underlying business, though. If we have somebody that we think is extraordinary, but they’re locked into one of those terrible businesses - because we’ve been in some terrible businesses - the best thing you can do, probably, is get out of it and get into something else. But there’s an enormous difference, frankly, in the talent of American business managers. The CEOs of the Fortune 500 are not selected like 500 members of the American Olympic track and field team. It is not the same process. And you do not have the uniformity of top quality that you get with the American Olympic team in any sport. You do not get that in top management in American business. You get some very able people, some terrific people, like a Bill Gates (Trades, Portfolio), that we just mentioned. But you get a lot of mediocrity, too. I think, in some cases, it’s fairly identifiable who has done an extraordinary job. And we like people that have batted .350 or .360, in terms of predicting that they’re going to bat over .300 in the future… And then we try to figure out what their attitude is toward shareholders. And that isn’t uniform either throughout corporate America. It’s far from uniform. We still want them to be in a good business, though. I would emphasize that. I gave the illustration of Tom Murphy in the annual report. I mean, no one could top his ability or integrity, in terms of the way he ran Cap Cities for decades. And you could see it in 50 different ways. He was thinking about the shareholders. And he not only thought about them, he knew what to do to forward their interests, and in terms of building the business, he only built it when it made sense, not when it did something for his ego or to make it larger alone. He did it when it was in his shareholders’ interests. They’re not all Tom Murphy’s. But when you find them, and they’re in a decent business, you want to bet very heavily and not make the same mistake I made by selling out once or twice.

I’m always interested in how Buffett talks about great businesses, particularly as it relates to the role of management. He said the extraordinary individual who finds themself in a bad business should focus on getting out of the bad business, not trying to fix it. He speaks from personal experience: Buffett spent many years trying to salvage Berkshire’s textile mill business, but ultimately it was all for naught. It was the decision to shift into businesses like insurance (through the $7 million acquisition of National Indemnity in 1967) that led Berkshire in the right direction. But even then Berkshire periodically found itself in difficult businesses (for example, Dexter Shoe Co.). This is where the importance of management comes in. You need someone at the helm who is capable of recognizing a lost cause and is both willing and able to make the tough decisions associated with moving out of that business. Said differently, you’ll find that great managers are uniquely able to move their enterprise into great businesses (for example, think about Jeff Bezos and Amazon (AMZN), which has moved into businesses like third-party seller services and cloud computing over time). As a corollary, they’re also good at moving out of bad businesses when they stumble into them. From an investment perspective, the sweet spot is when you find a great manager running a good business – like Tom Murphy at Cap Cities. As Buffett says, on the rare occasion when you find that elusive combination, “bet very heavily.”

Diversification

Later in the meeting, Buffett and Charlie Munger (Trades, Portfolio) were asked about their lack of disclosures on small equity positions (at that time, Berkshire did not discuss positions with a market value of less than $600 million in the shareholder letter). In answering the question, Buffett discussed his views on concentrating Berkshire’s capital into his best ideas, as opposed to widely diversifying the portfolio as is commonly practiced in the investment profession:

“We like to put a lot of money in things that we feel strongly about… Diversification, as practiced generally, makes very little sense for anyone that knows what they’re doing. Diversification is a protection against ignorance. If you want to make sure nothing bad happens to you relative to the market, you own everything. There’s nothing wrong with that. That is a perfectly sound approach for somebody who does not feel they know how to analyze businesses. But if you know to analyze and value businesses, it’s crazy to own 30, 40, 50 stocks because there aren’t that many wonderful businesses that are understandable to a single human being, in all likelihood. And to have some super-wonderful business, and then put money in number 30 or 35 on your list of attractiveness and forego putting more money into number one, just strikes Charlie and me as madness. It’s conventional practice, and if you all you have to achieve is average, it may preserve your job. But it’s a confession, in our view, that you don’t really understand the businesses that you own. On a personal portfolio basis, I own one stock. But it’s a business I know. And it leaves me very comfortable. Do I need to own 28 stocks, to have proper diversification? It’d be nonsense. And within Berkshire, I could pick out three of our businesses. And I would be very happy if they were the only businesses we owned, and I had all my money in Berkshire… three wonderful businesses are more than you need in this life to do very well. And the average person isn’t going to run into that. I mean, if you look at how the fortunes were built in this country, they weren’t built out of a portfolio of 50 companies. They were built by someone who identified a wonderful business. Coca-Cola’s (NYSE:KO) a great example. A lot of fortunes have been built on that company. And there aren’t 50 Coca-Colas. There aren’t 20. If there were, it’d be fine. We could all go out and diversify like crazy among that group and get results that would be equal to owning the really wonderful one. But you’re not going to find it. And the truth is, you don’t need it. A really wonderful business is very well protected against the vicissitudes of the economy over time and competition. I mean, we’re talking about businesses that are resistant to effective competition. And three of those will be better than 100 average businesses. And they’ll be safer, incidentally. I mean, there is less risk in owning three easy-to-identify, wonderful businesses than there is in owning 50 well-known, big businesses. And it’s amazing what has been taught, over the years, in finance classes about that.

What jumps out to me is Buffett’s commentary on investment risk, which is best captured in his thoughts about the wonderful businesses (“very well protected against the vicissitudes of the economy over time and competition”). In his mind, if you can own businesses that are strong in the good times - and even stronger (on a relative basis) in the bad times – that’s the least risky business you can be in. If you can find three or four of them, you’re set for life.

Note how different that view of risk is than the lens used by many investment “professionals” (like fund managers and investment advisors), who are primarily concerned with the career risk that comes with short-term underperformance. Given that this is an unavoidable reality if you’re going to be active, many simply choose to play a different game. They conclude that the way to succeed (in terms of lining their own pockets) isn’t to focus on the investment part of the business (making intelligent and meaningful investment decisions for their clients); it’s to focus on the gathering and retention of client assets. That conclusion leads these individuals to broadly diversify client portfolios, ensuring that no bet is large enough to meaningfully hurt – or help – the overall results. In my opinion, it’s an approach that is highly likely to lead to results that are similar to the broader stock market over time (said differently, it’s closet indexing). Which, to be clear, there’s nothing necessarily wrong with. (It's can simply amount to a bunch of wasted time and effort.) There’s a fairly clear distinction between the two. It’s when you get passively managed outcomes with actively managed costs that the investor (client) inevitably loses (at least relative to maintaining ownership of a low-cost index fund over the long run).

Walt Disney

Near the end of the session, Buffett and Munger were asked about The Walt Disney Co. (NYSE:DIS). At the time, Berkshire owned 3.6% of Disney, with a value of $1.7 billion. (In early 1996, Berkshire exchanged their Cap Cities shares for a combination of cash and Disney stock). The shareholder was interested to know if Buffett and Munger were concerned that Jeff Katzenberg, the head of Walt Disney’s Studio business, had left the company. Here’s what they said:

Buffett: “Katzenberg is a real talent. I would say that, by far, the most important person at Disney in the last 12 years has been [CEO] Michael Eisner. If you know him and what he has done in the business, there’s no one… [former President and Chief Operating Officer] Frank Wells did a terrific job in conjunction with Eisner. But Eisner has been the “Walt Disney,” in effect, of his tenure. He knows the business. He loves the business. He eats and lives and breathes it. He has been, in my view, by far, the most important factor in Disney’s success. Now, they face competition. The big money is in the animated films and everything that revolves around that, because you go from films to parks to character merchandising and back. And it’s a circular sort of thing, which feeds on itself. There’s going to be plenty of competition in that. You’ve seen what MCA and Universal’s going to do in the parks in Florida. And you know what DreamWorks is going to do in animation. And now, you’ve got new technology in animation, through [Pixar CEO] Steve Jobs. And there’s a lot of things going on in that field. So the question is, ten years from now, what place in the mind - because it’s a share of mind; they call it share of market, but it starts with share of mind - what place in the mind of billions of children around the world, and their parents, does Disney itself have, and their characters, relative to that owned by other organizations and other characters? And it’s a competitive world, so there will be people fighting for that. I would rather start with Disney’s hand than anyone else’s by some margin. And I would rather start with Michael Eisner running the place than with anyone else, by some margin. So that does not mean that it can’t become a much more competitive business. People look at the video releases of “Lion King,” and they salivate - you sell 30 million copies of something at $16 or $17, and you can figure out the manufacturing cost, it gets your attention. And it gets your competitors’ attention. But going back, if I thought the children of the world were going to want to be entertained 10 or 20 years from now, and I had my choice of betting on who is going to have a special place, if anyone has a special place, in the minds of those kids and their parents, I think I would probably rather bet on Disney. And I would feel particularly good about betting on them, if I had the guy who has done what Eisner has done over those years presiding in the future.”

Munger: “I think it helps to do the simple arithmetic. Suppose you have a billion children of low-to-middle income 20 years from now. And suppose you could make $10 per year per child, after taxes, from your position. It gets into very large numbers. I don’t know about your children and grandchildren, but mine want to see Disney. And they want to see it over and over and over again. They don’t want to see Katzenberg.”

Buffett: “They want to see them over and over again, and it’s kind of nice to be able to recycle Snow White every seven or eight years. You hit a different crowd. It’s kind of like having an oil field, where you pump out all the oil and sell it. And then it all seeps back in over seven or eight years.”

As a Disney shareholder, I find it fascinating that much of this commentary still applies today. Twenty-five years later, the company still has an ability to monetize its intellectual property through theaters, theme parks, and consumer products, in a way that has not been replicated by any of its competitors (Comcast (NASDAQ:CMCSA) has tried, but I would argue they still have a long way to go). But I also think it’s important to recognize how much good fortune was needed for Disney to where it’s at today, most notably in terms of their marquee brands and characters. Specifically, the deals that were completed under the leadership of former CEO Bob Iger – the acquisitions of Pixar, Marvel and LucasFilm (Star Wars) - significantly improved the company’s content creation engines and IP. With hindsight, it’s interesting to consider how important those deals were to the company. Where would Disney be today if they had not managed to complete these acquisitions? From the perspective of a long-term Disney shareholder, that’s a somewhat frightening thought – and it may explain why Buffett sold his Disney position in the late 1990's when the stock performed well.

Disclosure: Long Berkshire, Disney and Comcast.

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About the author:

The Science of Hitting
I desire to own high-quality businesses for the long-term. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with the top five positions accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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