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 (BRK.A, 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 meeting. I will select a handful of quotes from each section that I think are most insightful for investors.
With that, let’s take a look at the 1997 afternoon session.
Diversification and concentration
Early in the session, Buffett and Munger were asked about their investment process. Buffett used the opportunity to discuss intrinsic value, along with the differences between an investor and a speculator. When it was Munger's turn, he began by discussing the importance of opportunity costs:
“I would argue that one filter that’s useful in investing is the simple idea of opportunity cost. If you have one opportunity that you already have available in large quantity, and you like it better than 98% of the other things you see, well you can just screen out the other 98% because you already know something better. So, people who have a lot of opportunities tend to make better investments than people that don’t have a lot of opportunities. And people who have very good opportunities, using a concept of opportunity cost, can make better decisions about what to buy. With this attitude, you get a concentrated portfolio, which we don’t mind. That practice of ours, which is so simple, is not widely copied. I do not know why. Now, it’s copied among the Berkshire shareholders. I mean, all of you people have learned it. But it’s not the standard in investment management, even at great universities and other intellectual institutions. If we’re right, why are so many eminent places so wrong?”
I’ll take a shot at answering Munger's question: the reason why this approach to portfolio construction is not copied in standard investment management is because the incentives are misaligned. Your typical investment advisor will preach ad nauseum about the benefits of diversification – which, to be fair, is a real benefit for someone who is generally uneasy with the vicissitudes of the broader market, let alone the swings that you can experience in a highly concentrated portfolio. But something you will rarely, if ever, hear an investment advisor discuss is the cost of diversification. To Munger’s point, why would you allocate capital to a new idea if you can buy more of something that you already understand that offers more attractive expected returns?
In my experience, most investment advisors are uncomfortable making meaningful bets on behalf of their clients. And this is probably a good thing, considering that many of them are better at financial planning or addressing behavioral client issues than they are at investing. The reality is that, for advisors, the career risk associated with really pushing a single bet is too high. And, for that reason among others, the industry has not changed in the 20+ years since Munger made this comment. People continue to pay high fees for performance that, in the majority of cases, could be replicated over the long-term through ownership of an index fund.
A choice between good or big
Later in the meeting, Buffett and Munger were asked about some of Berkshire’s insurance businesses, and whether they can become larger over time. Here’s what they said:
Buffett: “Sometimes in insurance you have a choice between being a good business or a big business. Fortunately, Don Towle, who runs Kansas Banker Surety, has chosen to be a good business. It’s a specialized operation that sells, as its name implies, to bankers - primarily policies that have fidelity coverage. That is just not a big volume business in the whole United States. They do it exceptionally well… But it’s not an operation that can double or triple in size doing what it does and doing well. There just aren’t the opportunities there. On the other hand, I think it’s tough to compete against Don because he brings an element of knowledge and personal attention to the account and factors of that sort that a really large company would have trouble duplicating.”
Munger: “There’s a huge class of businesses in America which are very strong and will throw out large amounts of cash in relation to their size but which can’t rationally be expanded very much. And if you try and expand certain kinds of businesses, you’re throwing money down the rat hole. The beauty of the Berkshire Hathaway system is that such businesses are very welcome here because the cash comes into headquarters and is allocated there. If there’s anything sensible to do at the subsidiary level, we always want it done. But there are lots of businesses where there isn’t much of a way of redeploying the cash.”
Buffett: “Part [of] the reason they have a moat around them is that they’re of a size and have specialized skills that other organizations just can’t get into it… There are businesses that have certain natural limits. You want to be careful that you don’t talk yourself into thinking a business that has limits and find out that it really has way more potential. I mean, it would’ve been a shame if Mr. Candler decided that Coca-Cola (KO) only appealed to people in Atlanta or something of the sort. So, you have to be a little careful on that. But a fellow like Don will be very good at understanding, where his competitive advantages can take him and where they don’t take him. He’s done a terrific job over the years doing it.”
As Buffett first explains, there are certain businesses that can generate attractive returns on invested capital, but they may be of limited scope. What they need to protect against, as Munger says, is the desire to use the cash flows from the good business to try and chase growth in other areas. More often than not, if that path is pursued by a manager who is not well versed in capital allocation, that activity is the equivalent of “throwing money down a rat hole.” The beauty of Berkshire is that businesses can retain capital for growth as needed, or they can send it up to the parent company where it can (hopefully) be intelligently reinvested via outside investments (M&A, equity investments, etc) or within other Berkshire subsidiaries. The dollars are fungible, with the system ensuring - through the subsidiary managers' incentives - that those funds are funneled to their highest and best use. As the results since 1965 show, it’s an approach that has worked over the long run.
Buffett’s biggest investment mistake
Near the end of the session, Buffett and Munger were asked how uncertainty within a business impacts their assessment of its intrinsic value. Here’s what they said:
Buffett: “Obviously, if you understood the future of a business perfectly, you would need very little in the way of a margin of safety… The biggest thing to do is understand the business. Understand the business and get into the kind of businesses where by their nature surprises are few. And we think we’re largely in that type of business. I’ve talked about learning from your mistakes; the best thing to do is learn from other guys’ mistakes. U.S. General George Patton used to say, “It’s an honor to die for your country. Make sure the other guy gets the honor.” Our approach is to try and learn vicariously. But there’s a lot of mistakes that I’ve repeated, I can tell you that. The biggest category over time is being reluctant to pay up a little for a business I knew was really outstanding, or to continue to buy it at higher prices when I knew it was outstanding. The cost of that has been many, many billions. And I’ll probably keep making that mistake. The mistakes are made when there are businesses you can understand and they’re attractive and you don’t do something about it. I don’t worry at all about the mistakes that come about because when I didn’t buy Microsoft (MSFT) when I met Bill Gates (Trades, Portfolio). That’s not my game. Most of our mistakes have been mistakes of omission rather than commission.”
Munger: “I think most people get very few, what I call, no-brainer opportunities, where it’s just so damned obvious that this is going to work. And since they are very few and they may be separated by periods of years, I think people have to learn to have the courage and the intelligence to step up in a major way when those rare opportunities come by.”
Buffett: “You got to be willing to take a really big bite. And it’s crazy if you don’t. And it’s crazy if you dabble around at the edges so you’re not prepared to take a big bite when the time comes.”
As Munger suggests, you are likely to see but a handful of these no-brainers over an investment lifetime. When you do, after potentially waiting years for one of these rare opportunities to present itself, you also need to have the intelligence to recognize it, as well as the courage and the capital to take a big swing.
Hopefully when one of these opportunities appears in your life, you'll be ready to act.
Disclosure: Long BRK.B and MSFT
Read more here:
- Berkshire Hathaway Meeting: 1997 Morning Session
- Nike: Digital Shines, but a Tough End to 2020
- Disney Valuation, Part 4: Live Media and ESPN+
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