Does 'Don't Lose Money' Hurt Berkshire Shareholders?

A look at an email exchange between a former Microsoft employee and Warren Buffett

Aug 25, 2020

In 1997, Warren Buffett (Trades, Portfolio) and Microsoft (MSFT, Financial) employee Jeff Raikes exchanged a few emails discussing the long-term business case and investment rationale for Microsoft. In his first email to Buffett, Raikes wrote the following: "In some respects, I see the business characteristics of Coca Cola (KO, Financial) or See's Candy as being very similar to Microsoft."

He went on to explain the company's dominant operating systems (OS) business, with the vast majority of the 50 million PC's sold around the globe that year running a Microsoft OS (Windows). In addition, Raikes explained that on top of the ability to raise the price for Windows over time, volumes would grow quickly in the ensuing years as well, with the number of PC's sold around the world expected to double to 100 million a year by 2000. Raikes concluded with the following comment about the OS business: "I'm sure the profits are probably as good as the syrups business!"

He also wrote about Microsoft's software businesses, most notably the Office productivity suite, which had roughly 90% market share at the time, with $5 billion in annual revenues and 85% operating margins.

Raikes summed up his case for Microsoft, saying "So, I really don't see our business as being more difficult to understand than the other great businesses you've invested in."

In Buffett's response, I want to focus on the following comments:

"Bill Gates (Trades, Portfolio) has an even better royalty [than Coca-Cola] – one which I would never bet against but I don't feel I am capable of assessing probabilities about, except to the extent that with a gun to my head and forced to make a guess, I would go with rather than against. But to calibrate whether my certainty is 80% or 55%, say, for a 20-year run would be folly. If I had to make such decisions, I would do my best, but I prefer to structure investing as a no-called strikes game and just wait for the fat one. I watched Ted Williams on cable the other day and he referred to a book called "The Science of Hitting" which I then ran down. It has a drawing of the batter's box in it that he had referred to on the show with lots of little squares in it, all parts of the strike zone. In his favorite spot, the box showed .400 reflecting what he felt he would hit if he only swung at pitches in that area. Low and outside but still in the strike zone he got down to .260. Of course, if he had two strikes on him, he was going to swing at that .260 pitch but otherwise he waited for one in the 'happy zone' as he put it. I think the same approach makes sense in investing. Your happy zone, because of the business experience you have had, what you see every day, your natural talents, etc. is going to be different than mine. I am sure, moreover, that you can hit balls better in my happy zone than I can in yours just because they are fatter pitches in general."

The decision, based on Buffett's perspective, is only worth further consideration if it passes his first filter: the certainty with which you can assess the future of the business. Buffett believed he could foresee Coca-Cola's position in the soft drinks business with near 100% certainty ("as long as cola doesn't cause cancer"), but he could only venture a guess as to whether Microsoft was more likely than not to be successful 20 years down the line. He equated his thinking to the way Ted Williams approached hitting - with the added benefit that, in the game of investing, there are no called strikes.

This focus on the certainty of the long-term prospects of the business is captured in one of Buffett's most well-known quotes: "Rule #1: Don't lose money. Rule #2: Don't forget rule number #1."

Personally, I do not think that a higher than expected possiblity of losing money should disqualify an investment idea (as part of a broader portfolio). I'm willing to invest in something with an outsized probability of being a dud or even a zero if I think that consideration is more than offset by its upside potential. This way of thinking was summarized by Stan Druckenmiller in an interview in 2018:

"I try to develop a thesis that others haven't. I put the positions on. Then when they start to go my way, I pile onto them. It's what my partner, George Soros (Trades, Portfolio), was so good at. It's a slugging percentage rather than batting average mentality."

Taken at face value, the "Don't lose money" approach to investing fails to consider what may be "lost" - in terms of opportunity costs - by missing out on a business with attractive long-term prospects that you understand, even if you cannot predict its cash flows 20 years out with near certainty. This is where I (and Raikes) think a company like Microsoft fits for Buffett:

"I've had this sneaking suspicion that it is not that you don't understand this business… My theory is that you don't invest in technology or Microsoft because you see the moats as narrower; too much risk and the potential for a fast paradigm shift that would be too quick to undermine your equity position."

Let's move beyond Microsoft, because Buffett has had a close relationship with Bill Gates (Trades, Portfolio) that likely would've precluded him from making an investment under any circumstances given the optics (people would assume no matter what that he was acting on inside information).

Instead, let's look at another example: Alphabet (GOOG, Financial)(GOOGL, Financial). At the 2017 shareholder meeting, Charlie Munger (Trades, Portfolio) said the following in response to a question about Berkshire's investments in tech companies like IBM (IBM, Financial) and Apple (AAPL, Financial):

"Well, we avoided the tech stocks because we felt we had no advantage there and other people did. And I think it's a good idea not to play where other people are better. But, if you ask me, in retrospect, what was our worst mistake in the tech field? I think we were smart enough to figure out Google. Those ads worked so much better in the early days than anything else. So, I would say that we failed you there. We were smart enough to do it and didn't do it."

Buffett added the following:

"We were their customer very early on with GEICO, for example. As I remember, we were paying them $10 or $11 dollars a click or something like that. And any time you're paying somebody $10 or $11 bucks every time somebody just punches a little thing [on a computer] where you've got no cost at all, that's a good business, unless somebody's going to take it away from you. And so, we were close up, seeing the impact of that… And I knew the guys. I mean, they actually designed their prospectus. They came to see me… So, I had plenty of ways to ask questions or anything of the sort, educate myself. But I blew it."

On Google, I think it's unreasonable to give them grief for missing it in the early days (around the IPO). The period that I want to focus on is during the financial crisis. At that time, they had watched the business model continue to work for a few years. In addition, Google's competitive position was clearer and more well established than it had been five years earlier. To me, the idea that Buffett and Munger could not make a reasonable assessment about the viability of the enterprise over the ensuing decade or so seems farfetched, especially since they understood its appeal from an advertiser's perspective and could see that Google had dominant market share among consumers.

Around the time of the financial crisis, from a high of more than $350 per share in October 2007, Google's stock fell by more than 50% over the next year to a low of less than $150 per share. For the year 2008, Google reported GAAP net income of $4.2 billion, or $13.3 per share. At the end of 2008, they also had $16 billion in cash and equivalents on the balance sheet and no debt.

Was the investment a cinch in terms of business certainty (batting average)? Absolutely not. But I think Buffett and Munger, given their understanding of how effective the advertisering products were to its buyers, as well as the attractive incremental economics of the business, were in a position to understand that, at the price offered, the investment may have made sense for Berkshire on its expected value (slugging percentage). That continued to be the case over the ensuing decade before Munger told shareholders in 2017 that he and Buffett had made a mistake.

I think there are other examples over the past 20 years that fit this model - a notable one being Costco (COST, Financial), which Buffett first called an error of omission in 2000. Again, I think the outcome suggests Buffett may have been too rigid when it came to his first filter.

In summary, the idea that the certainty of the enterprise should far outweigh the potential upside from an investment in the business over 20 years is a questionable premise, in my opinion. I think Buffett's and Munger's own words suggest that they may admit to making this mistake as well.

Conclusion

As we think about Berkshire today, I think this discussion has become even more important. The company is sitting on more than $140 billion in cash and equivalents, of which more than $100 billion could be invested tomorrow if the right opportunity arose. Given the necessary size for any investment to make a dent on Berkshire's balance sheet, the investable universe continues to shrink. In terms of publicly traded companies, Buffett basically needs to find a company with a market cap in excess of $100 billion to really move the needle (so he can put $5 billion, $10 billion, or more to work). That list, as we all know, is increasingly populated by technology companies like Google, Microsoft, Apple and Amazon (AMZN, Financial). Ultimately, Buffett and Munger will either need to invest roughly $100 billion or just throw up their hands and return it to shareholders through repurchases or dividends. Buffett spoke about this problem at the 1994 shareholder meeting:

"If we have cash, it's because we haven't found anything intelligent to do with it that day... we have well over $1 billion of cash around, and that's not through choice. You can look at that as an index of failure on the part of your management."

With the cash balance growing larger and larger, and the investable universe becoming smaller and smaller, the game has become tougher. As opposed to being able to wait patiently with the bat on his shoulders, it's looking more and more like Buffett is at the plate with two strikes. That reality, along with the fact that technology companies appear likely to constitute a large percentage of the mega cap universe in the years and decades to come, may require some evolution in his views on the definition of a .400 pitch. I think Buffett may need to accept reasonable investments as measured on slugging percentage as opposed to batting average before he can really start swinging again (and in his defense, I think the investment in Apple a few years ago may be an example of him doing that).

Throughout their lives, Buffett and Munger have managed to continually improve as investors. My hope is that they will take the lessons learned from a few misses in the past 10 or 20 years into consideration as they embark on their final chapter as the leaders of Berkshire Hathaway.

Disclosure: Long Berkshire Hathaway Class B and Microsoft