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The Science of Hitting
The Science of Hitting
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Berkshire Hathaway Meeting: 1997 Morning Session

Highlights from a past annual meeting

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 the meetings. I will select a handful of comments from Buffett and Charlie Munger (TradesPortfolio) that I think are most insightful for investors. With that, let’s take a look at the 1997 morning session.

Great businesses at bad prices

Early in the session, Buffett was asked about some comments he made in the shareholder letter about companies like Coca-Cola (NYSE:KO) and Gillette (which was acquired by Procter & Gamble (NYSE:PG) in 2005 for $57 billion). Here was his response:

“I talked about Coke and Gillette as being 'The Inevitables,' and what wonderful businesses they were. And I thought it was appropriate that people would not take that as an unqualified ‘buy’ recommendation, because they’re absolutely wonderful companies run by outstanding managers, but you can pay too much, at least in the short run, for businesses like that. So I thought it was only appropriate to point out that no matter how wonderful a business it is that there is always a risk that you will pay a price where it will take a few years for the business to catch up with the stock. The stock can get ahead of the business. And I don’t know where that point is with those companies or any other companies, but I did say that I thought that the risks were fairly high that that situation existed with most securities in the market, including companies such as 'The Inevitables.' But it was designed to be sure that people did not take the remarks that I made about those companies as an unqualified buy recommendation regardless of price. We have no intention of selling those two stocks. We wouldn’t sell them if they were selling at prices considerably higher than they are now. But I didn’t want relatively unsophisticated people to see those names there and then think, 'This guy is touting these as a wonderful buy.' Generally speaking, I think if you’re sure enough about a business being wonderful, it’s more important to be certain about the business being a wonderful business than it is to be certain that the price is not 10% too high or 5% too high. And that’s a philosophy that I came slowly to. I originally was incredibly price conscious. We used to have prayer meetings before we would raise our bid an eighth. But that was a mistake. And in some cases, a huge mistake. We’ve missed things because of that. We never try to predict the stock market. We do try to price securities. We try to price businesses. And we find it hard to find wonderful, good, average, substandard businesses that look to us like they’re cheap now. But you don’t always get a chance to buy things cheap.”

There are two parts of Buffett’s answer that I find interesting.

First, even when he says they never try to predict the stock market, he followed by saying that publicly traded companies, broadly speaking, did not appear attractively priced to him (“find it hard to find wonderful, good, average, substandard businesses that look to us like they’re cheap now”). The distinction is one of time horizons: while Buffett would never comment on the short-term outlook for equities, he has on occasion commented on the long-term outlook. By May 1997, he was becoming increasingly vocal about the lackluster long-term returns that he believed were being offered by U.S. equity markets.

Second, I find it interesting how he translates that belief about securities prices broadly into his portfolio decisions. As he noted, and as was subsequently confirmed by his (lack of) activity in the next few years, he had no intention of selling Coca-Cola or Gillette, even as they reached prices that seemed expensive. In addition, as he stated, that would continue to be the case at “considerably higher” prices. (Note that Coca-Cola common stock closed 1996 with a trailing price-earnings multiple of nearly 40.) With hindsight, we can see that holding the stock has not worked out well over the ensuing 23 years: Today, Coca-Cola trades at $45 per share, an increase of less than 50% from its price in 1997 (without accounting for dividends).

Investment risks

Later in the meeting, Buffett and Munger were asked about how they define business risk. In answering the question, Buffett discussed four different layers of risk in investing:

“We think first in terms of business risk… People in this room own a piece of a business. If the business does well, they’re going to do all right as long as they don’t pay way too much to join into that business. So, we’re thinking about business risk. Now, business risk can arise in various ways. It can arise from the capital structure when somebody sticks a ton of debt into some business, so that if there’s a hiccup in the business then the lenders foreclose. It can come about just by the nature of the business; certain businesses are just very risky… Commodity businesses have risk unless you’re the low-cost producer because the low-cost producer can put you out of business. Our textile business was not the low-cost producer. We had a fine management, everybody worked hard, we had cooperative unions, all kinds of things. But we weren’t the low-cost producer, so it was a risky business. The guy who could sell it cheaper than we could made it risky for us. So, there’s a lot of ways businesses can be risky. We tend to go into businesses that inherently are low-risk and are capitalized in a way that that low risk of the business is transformed into a low risk to the enterprise. The risk beyond that is that even though you identify such businesses, that you pay too much for them. That risk is usually a risk of time rather than loss of principal unless you get into a really extravagant situation. But then the risk becomes the risk of you yourself - whether you can retain your belief in the real fundamentals of the business and not get too concerned about the stock market. The stock market is there to serve you, not to instruct you. And that’s a key to owning a good business and getting rid of the risk that would otherwise exist in the market.”

The risks, as outlined by Buffett, fall into four categories: (1) the risk associated with owning a subpar business; (2) financing risk from leverage and / or liquidity issues; (3) valuation risk from paying too much for the asset; and (4) behavioral risk from relying on the opinions of other market participants. Being a successful long-term investor requires the ability to assess and roughly quantify the potential impact of each of the first three risks, along with the temperament to live with the fourth risk.

Active management

Near the end of the session, the gurus were asked about a comment at an earlier shareholder meeting – specifically that money managers in the aggregate had not done better than market indexes, partly due to the frictional costs inherent in an actively managed portfolio. The shareholder asked if they could update their thoughts on the topic. Here’s what Buffett said:

“Money managers, in the years since I made that statement, have not disappointed. In aggregate, they have underperformed index funds. And it’s the nature of the game. They simply cannot overperform, in aggregate. There are too many of them managing too big a portion of the pool. It’s for the same reason that the crowd could not come out here to Ak-Sar-Ben and make money, in aggregate, because there was a bite being taken out of every dollar that was invested in the pari-mutuel machines. People that invest their dollars elsewhere through money managers in aggregate cannot do as well as they could do by themselves in an index fund. They say you can’t get something for nothing. But the truth is money managers, in aggregate, have gotten something for nothing. I mean, they’ve gotten a lot for nothing. And the corollary is investors have paid something for nothing. And that doesn’t mean that people are evil. It doesn’t mean that they’re charlatans or anything. It’s the nature, if you got a $6 trillion or $7 trillion equity market, and you have a very significant percentage of it managed by professionals, and they charge you significant fees to invest with them, and they have costs when they change around. They cannot do as well as unmanaged money, in aggregate. And it’s the only field in the world that I can think of where the amateur, as long as he recognizes he’s an amateur, will do better than the professional… Charlie and I would be glad to take any money management organization in the world managing $10 billion or more, and we would be willing to bet that their aggregate investment experience over the next 5-10 years for the group that they advise will be poorer than that achieved by a no-load, very low-cost index fund. We’d put up a lot of money to make that wager with anybody that would care to step forward.”

A decade later, Buffett found a counterparty for that bet. In December 2017, Protégé Partners agreed to make a $1 million wager against the S&P 500, with Protégé selecting five funds-of-funds which in turn owned an interests in more than 200 hedge funds. Protégé believed that these funds, even after paying hefty fees, would outperform the index over the next 10 years.

The final results did not live up to their expectations: from 2008 to 2017, the S&P 500 delivered an annualized return of 8.5%; as shown below, the funds-of-funds selected by Protégé Partners collectively delivered returns that trailed the S&P 500 by a wide margin over the same period.

Not only did the wager help to support a worthwhile cause – $2.2 million to Girls Inc. of Omaha – but investors and shareholders received another important lesson on the deleterious impact of high fees in a highly competitively endeavor like investing.

Disclosure: Long Berkshire Hathaway's class B stock.

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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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