Roundup of the Berkshire Hathaway Meetings

[HenryTo]

Great article on partially how Buffett and Munger succeeded in their investment careers:
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Roundup of the Berkshire Hathaway Meetings
Wednesday May 18, 7:00 am ET
By Dreyfus Neenan

You can often learn a lot simply by watching. So at the 2005 Berkshire Hathaway (brk.a.A) (brk.b.A) annual meetings--the shareholder meeting in Omaha, the subsequent analyst/news briefing (which is not open to the public or shareholders) and at Wesco Financial's (AMEX:WSC - News) annual meeting in Pasadena, Calif.--we watched. And listened. We've parsed our notes and selected what we think were chairman Warren Buffett and vice chairman Charles Munger's most salient insights for investors.

We don't produce verbatim transcripts--we can neither write quickly nor listen infallibly--but we do believe that we've captured the essence of Buffett and Munger's thoughts. In any event, Berkshire will conduct meetings again next year, and any shareholder may attend. As a bonus, we think Berkshire shares look cheap at the moment, which isn't a bad way to acquire an admission ticket. However, anyone can attend the Wesco meeting, which is usually more intimate, and the odds of being selected to ask a question are substantially higher. What's more, we have already shared some insights on the Berkshire meeting in an earlier commentary. But now to the good stuff.

Berkshire's Moat
"We have severe intellectual limitations compared to the best."
Economic profits are generally a transitory phenomenon in capitalist economies, as competitors eventually materialize to appropriate them. This is especially true of investment returns, which presents a puzzle when it comes to Buffett and Munger. Whether investing individually as hedge fund managers, or jointly via Berkshire and Wesco, both have earned abnormally large investment returns for more than 40 years. What's more, their returns have persisted in a market populated with very smart, hardworking investors, many of whom have adopted Ben Graham's thinking and religiously read anything that Buffett and Munger have said. So it seems that Berkshire enjoys a reasonably wide economic moat around its investment returns. (For more on moats, read here, here, here and here). But what is its origin? We asked.

Buffett's answer was instructive. "Financial success doesn't perfectly correlate with I.Q. ...but with temperament, which is hard to measure. You need some I.Q., but temperament is key." In elaborating, Buffett explained that he thought it was partly because they knew where they ranked on the intellectual scale and had a strong idea of the boundary of their circle of competence. He also noted that it took a certain temperament to be able to make independent judgments and not be influenced by others. "The difficulty is that you will be continuously offered many different things [by the markets]." Munger said he believes their advantage is that they have a better understanding of what they don't know, and even noted that a 200 I.Q. would be a disadvantage, as it would likely foster overconfidence. "See yourself as you are, not as you hope to be."

Those familiar with recent academic research into behavioral finance may notice the parallels with the concepts of overconfidence and heuristics. Yet behavioral traps can be tough to combat. Even Buffett and Munger noted how difficult they find it to navigate the investment markets with mental effectiveness, but they believe that they are intrinsically wired to be less susceptible. Buffett noted, "The first step is recognition...(and) a lot of experience helps." It seems that at Berkshire, they simply try to make fewer mistakes than others. Perhaps that's a topic worth exploring in detail.

Upon reflection, we think temperament is a huge barrier--even if it can be difficult to grasp. But Berkshire's 2002 junk bond investments offer a helpful illustration. At the investor meeting, Buffett displayed a slide noting the multibillion dollar returns Berkshire had earned--most notably in Williams Companies (NYSE:WMB - News) bonds, which he bought at a 75% yield to maturity and then sold at a 6% YTM (a huge gain). Why did so many investors miss this opportunity? No doubt it was partly due to a market overreaction, as investor risk tolerances plummeted in a the face of waves of bad news. Yet arguably, an independent-minded, rational investor stood to profit enormously. How many of us could look back and honestly conclude we could have invested in the face of such tumult and rapidly declining market prices? But even if you cleared that hurdle, you would then have confronted an array of seemingly undervalued bonds--and the risk of buying blindly in a fit of greed. But not at Berkshire. Buffett explained how, even in the face of all that value, he adroitly stuck to what he knew--for example, by avoiding Huntsman Chemical bonds. We think this was a much tougher decision than it may sound.

We also found another interesting example of temperament's power in a less likely source--Berkshire's shareholders. We figure they are a nonrandom sample of more value-oriented investors steeped in Berkshire's philosophies, and they are generally wealthy enough that have less need to chase returns. Does this help shape temperament, or at least reflect positive self-selection? Well, several years ago, Buffett and Munger patiently answered endless questions about why Berkshire wasn't investing in then-hot tech stocks. This year, we counted at least 4 questions on gold, and at least 5 on real estate--the "hot" ideas of the day. It seems Berkshire shareholders are all too human as well. In our view, this is important evidence arguing for the difficulty of developing investment temperament--and the seductiveness of those investment ideas with the highest current trailing returns or media coverage. High demand for an investment leads to high prices, the investor's foe. Resistance is key. But could you develop this temperament?

(By the way, we think many investors and institutions can develop their own moats, and we'll explore how in a future research note.)

When to Sell
Berkshire's prominence as a buy-and-hold investor stems from the firm's large, long-term stakes in firms like Coca Cola (NYSE:KO - News) and The Washington Post (NYSE:WPO - News). But deeper down in the portfolio, as well as in Buffett's years as a hedge-fund manager, there is plenty of selling going on. Buffett noted that in his early days everything he sold was undervalued--he was simply compelled to move on to more enticing opportunities. These days, he noted that he has a deeper appreciation of the fact that in selling a security, "you have to be right twice." Berkshire's large position and unrealized capital gains have also constrained his flexibility. In making sell decisions, Buffett disdained the concept of a "cost of capital," noting that he simply based investment decisions on Berkshire's perceived opportunity costs--that is, trying to allocate capital to the firm's best opportunities. But we'll leave it to Munger to sum things up, "You want to increase your opportunity costs. That's the nature of an investment life properly run."

On Asset Prices, Competition, and Expectations
Berkshire investors repeatedly questioned whether asset prices were now 'too high', and how the current markets compared to earlier years--such as 1969--when prices were also high. Munger offered several insightful observations, in our view. He remarked that he had never experienced a similar situation, where he felt all asset prices were simultaneously overpriced. What's more, he predicted one of two outcomes: a classic economic bust, or "Japan," where a "silly boom" persists for years, then is followed by more than a decade of losses. But what really struck us was his comment that Berkshire has lowered its standards "a little. We're not waiting for another 1974/1982--the intelligent thing may be to accept a lower return than you are used to."

While it's possible that the pressure of investing Berkshire's rapidly accumulating cash horde may have motivated this thinking, we doubt it. In our view, this simply reflects the compounding opportunity cost of Berkshire's low returns on that cash. It seems to us that Berkshire may be waiting out the deluge of competition for acquisitions from private equity firms. Buffett and Munger both noted that these firms are willing to pay almost any price to get a deal done, as they would otherwise have to return investors' money--and forgo their fat fees. This may mean that Berkshire investors still face a long wait before the firm invests its cash, although Buffett and Munger separately noted that historically they had been surprised by how quickly markets could change, and, as a corollary, how important it is to be prepared.

A Positive Example CEOs Could Set
Munger summarized Berkshire's management system as, "It's wonderful to be trusted," and noted that everyone wants to be appreciated. He advocated trying to develop a "seamless web of deserved trust." Munger contends that such webs yield enormous efficiencies--you don't have to waste time continuously checking up on people--and given that Berkshire is managed with a corporate office of less than 20 people and hugely delegated managerial authority, we think he has a point. We'd like to see more CEOs exhibiting this thinking and, as investors, we recommend looking for these webs amongst management teams.

Reading/Viewing Recommendations
Buffett and Munger offered several reading suggestions this year, and we can only agree. Buffett is increasingly alarmed by the accumulating risks of nuclear terrorism, which is an obvious threat to society as well as Berkshire's reinsurance profits. He recommended Nuclear Terrorism, a related Web site, Last Best Chance and the Fog of War DVD. We think these are intrinsically worthy topics, but we also spy a lesson for investors--thinking laterally about risks. Terrorism may be an obvious risk for reinsurers, but perhaps there are less obvious risks circling your investments. Do you know what they are?

Buffett also recommended Poor Charlie's Almanac, a compilation of Munger's speeches and writings. We can't say enough good things about it. Other recommendations included F.I.A.S.C.O., a portrayal of poor investment banking behavior in the 1990s, and Conspiracy of Fools, which details the unmaking of Enron. And of course, Buffett mentioned his original inspiration, Graham's Security Analysis, several times.

Berkshire Stocks to Watch
Buffett and Munger customarily don't offer stock tips at the Berkshire meetings. However, that doesn't necessarily mean that Berkshire is bereft of opportunities, so we've scanned Berkshire's publicly disclosed stock portfolio in search of 5-star investment ideas. While some of these undoubtedly reflect Lou Simpson's stock-picking (Simpson manages a stock portfolio for GEICO; his record is equally daunting), we found 6 holdings that boast our 5-star rating as of the date of this article. We think they're a good place to start your research:

Anheuser-Busch (NYSE:BUD - News)
First Data (NYSE:FDC - News)
Iron Mountain (NYSE:IRM - News)
Washington Post
Coca-Cola
Wesco Financial