A PM Perspective: What’s So Special About Warren Buffett?

Study Notes:

Guest Information

https://www.linkedin.com/in/stefanograsso/

EVF@8vantedge.com 

Direct link to IBKR Podcast Episode

Guillaume Roux-Chabert

It’s a pleasure. All right, so maybe we can start, you have quite a story here. We can start from your first encounter with Warren Buffett, himself. When was that and how did it go?

Stefano Grasso

So, you know, I physically met Warren Buffett in 2013 in Omaha for one of the annual meetings that I attended in person and the meeting was very brief, but he pushed me to ask him a question at the following annual meeting. The question was regarding the leverage level for Berkshire Hathaway.

So, my question, my point, was basically given the transition the Berkshire at some point will go through from new management, future management—my question was why don’t they increase the leverage and basically leave a task for the next management to just deliver the balance sheet, a much easier task than finding very good investments and a more straightforward job to do. And when I asked this question, I got both Warren Buffett and Charlie Munger to answer and, you know, they basically, in essence, they said what you’re saying makes sense, is good. But we are very conservative and probably we’re not going to do that.

Anyway, the meeting goes by and usually there is a session in the morning, which is when I asked the question, and the break and then the session in the afternoon and it’s all, you know, Q&A, so 3 hours in the morning and few hours in the afternoon. So, when we come back after lunch, Warren Buffett turned to Charlie Munger and asked him, what do you think about this morning session? And Charlie Munger says, you know, whatever, fine as usual and asked Warren Buffett–for you, how was it? And Buffett says, I really like the question of the Italian fellow.

And so, you know, we heard that because the mic was on before the second session started, so I gave a hard time for the rest of the trip to my friends, like saying, you know, there were no other Italian fellow, so it was me. So that was fun.

Guillaume Roux-Chabert

Excellent. That’s a great story. OK, so I guess, since then you mentioned you’ve been constantly following Buffet’s moves—could you elaborate on what move you followed and what worked and what lesson did you learn, and did you also integrate this leverage point of view in your strategies?

Stefano Grasso

I think, you know, it got really intense for me—my exposure to Warren Buffet. After the first meeting I attended, I set up a daily e-mail alert with Google so every day I have been receiving a sort of, you know, collection of all the news of Berkshire Hathaway, Warren Buffett. When I was in the U.S, I was getting this in the morning and then I moved to London and then, you know, I went in Tanzania and for the last few years I was in Singapore.

So different time zones but that e-mail hit me, now is, you know, a different time of the day; I have been reading everything I could put my hands on for a period of probably I think— for the first eight years, I never skipped the day, you know, holiday, traveling, whatever. I always read everything to a point that, you know, I think I really got in-sync with their thinking and The Berkshire Hathaway. I mean, many times, I see some events, then I read the headlines, and I said no, guys you didn’t get it. I mean, he’s meaning something different, right? So, it has been a journey that, you know, without even meeting personally without talking with Warren Buffett, I kind of followed him and I, you know, I applied to the extent that it’s possible many of his strategies, thinking to my day-to-day job at Enhanced Value Fund. Of course, with the difference in size and the ‘man is the man,’ but still a good push to do its best.

Guillaume Roux-Chabert

Yeah, I mean, I guess, having this kind of exposure helps you synchronize with this thought process. And he always mentioned the trading as an intellectual process, integral thought process first and so beyond the emails that you mentioned and the exposure that you have with the automated alerts you mentioned. Also, you attach quite a particular importance to the famous Warren Buffett’s Annual letter to shareholder. And by the way, we will put the link in the podcast script for the audience and I think you’ve selected a few letters. So, shall we start maybe with the first one as it defines Warren Buffet’s initial trading philosophy, which was written back in 1977, if I’m not wrong.

Stefano Grasso

And you know, I think both the letter, transcript, and the recording of the annual meeting are really the best way to get the unfiltered Warren Buffett thinking. He really tries to, I mean to put this in his words, speak to, he says his sister, so no finance background person and explain the very complex development as it is, you know, one year of a conglomerate development with multiple different businesses and sectors—in very simple words and in plain English.

In the first letter, I think you know, I suggest the letters are few pages from really single digit to maybe 20 pages or so, very short. They cross from 77, so they go through, you know, crisis inflation, high interest rates, low interest rates; it’s really a journey and a reflection, year over year, over our times or over our economy. And the first letter laid out few concepts that then are picked up again and again and in the 77 he starts saying he starts making a distinction on how to report earnings. And he’s saying basically I could write to you that our operating earnings were up 37% from the year before, but this wouldn’t be fair because our beginning capital was also up 24%. So, if I just compare, you know, what you were saying, is if I just compare operating earnings, I say I’m 37% up but I’m using more capital, so I need to factor that in. So, he says that’s why I’m reporting that our operating earnings on beginning equity capital amounted to 19%, slightly better than last year and above our long term average. But still, he started laying out how he would like to, you know, kind of rid of financial information in a standard way that is basically taking out the noise from the growth and other things.

He basically says, you know, most companies they find record earnings when there is a new high, but that means very little if you have retained earnings because it’s the same that he’s saying, after all, even a totally dormant saving account will produce steadily rising interest earnings each year, just because of the compounding because you invest 100 next year is 105. If you make 5% and then, you know, the 5% is going to apply to 105, so it’s going to be higher and higher and so on. So, he’s basically saying I don’t want to take credit for that and I’m reporting you in this very straightforward way. Another point that came up in this very first letter is a concept that has been driving his investment strategy and career since the very beginning but consistently throughout— is that, he says, we prefer to invest —one lesson that he learned is the importance of being in businesses where tailwinds prevail rather than headwinds.

I mean another famous quote not in this letter is, you know, they say that they invested in Coke because Coke is such a great business that even an idiot could run it. So, the point is, I want to be in businesses that have such strong economics that they don’t need to worry about it for a few years. There is not the best guy running it, so this is something that already came out and you know, this is 77. He’s a young man and, you know, it’s very remarkable how few things that laid out there have been—he would say them in the same way after 50 plus years.

And lastly, he mentioned See’s Candy and See’s Candy had, at the time, pretax operating earnings of about you know 10 million. And of course, now the business has grown, as you know, probably worth several billions and this is a company that makes candies and is located in the West Coast, the US. And have been taught in Business School as a kind of remarkable business that was very quick to pay back to the shareholder, the purchase price and then kept giving dividends year in, year out and providing a very good return. So, these are the three things that I would alight about the 77 letter.

Guillaume Roux-Chabert

Yeah, that was in 1977 and we could tell he was already quite making sure not to over sell, which is quite unique when you read annual statements, in general, I have to say. So, moving on to another very important letter is the 1999 letter as this year he underperformed the S&P 500 and he was quite upfront about it, right? So, you told me, it tells a lot about the person itself—could you give us more insights and content on this 1999 letter?

Stefano Grasso

So, to put things in perspective, I mean, Berkshire had already quite a long track record, so the confidence in the business was definitely there. However, you know, there has been a couple of interesting years for Berkshire Hathaway because the letter is the 99 letter that was published in February or early March 2020, which was really in the middle of the ‘.com bubble,’ and as it periodically happened when there are bubbles, call it the crypto bubble everyone is talking, you know, taking the cap about, you know, Bitcoin, Ethereum and things. And basically, the old-fashioned investments are less interesting, less sexy, and money gets out to go where hot money is. And in the.com bubble, duringthe.com bubble, the Berkshire portfolio was very much missing that unstoppable rising of the part of the market, the NASDAQ, let’s call it.

So, in 99, the increase in book value per share—that was the yardstick that Buffett used for many years— increased only 0.5%, whereby the S&P increased 21% and the share price of Berkshire Hathaway decreased about 20%. So, there was basically a 40% underperformance in one year, that is something that is unheard of. You know, when you manage money, you never want to report underperformance. They have been always very clear what the yardstick were, the benchmark, and so that was up there. You know, you might want to say ‘, hey, just stay here it’s going to reverse back, don’t worry.’ He was so plain in admitting the underperformance, the facts, he starts saying the numbers on the facing page show just how poor our 99 record was. We had the worst absolute performance of my tenure and compared to the S&P, the worst relative performance as well. Relatively, relative results are what concern us, over time bad relative numbers will produce unsatisfactory absolute returns. And then he had my one subject, his capital allocation, and my grade for 1999—most assuredly, it’s a D, so he basically, you know, crucified himself at the very beginning of the letter and says, ‘this is what didn’t work, these are the businesses they had.’ Also, the problem were compounded by a reinsurance business that they bought that had underwriting losses and there was also a bit of, you know, noise.

But when the letter was written, Berkshire Hathaway was at the bottom—what turned out to be the top for the market and the bottom for the Berkshire, for the stock, Berkshire Hathaway. And the funny thing was that concluding the letter, he has a message of optimism and says, you know, we believe this is not reflecting the true, earning power of our company and we are almost certain that the S&P will do far less well in the next decade than it has done since the previous decade. And of course, then you go, you can check 10 years after this letter was written, the S&P was done. You know, maybe he included dividends was more or less, right.

Guillaume Roux-Chabert

Yeah, was he was proven right, landed.

Stefano Grasso

So, you have a guy that is in extreme under pressure that says, you know, this is what is happening in a very transparent way. And then says ‘, but by the way, I think, you know, the next decade, which is not a quarter prediction, I don’t see how this system can sustain itself as this rate has increased,’ and guess what, of course the S&P was flat, and Berkshire was like 2X or so in terms of capital appreciation. I think it’s a, you know, for aspiring money manager for people that are interested in investing, being true to oneself and just saying, you know, just being factual about what’s happening is a big thing to keep in mind.

Guillaume Roux-Chabert

Yes absolutely, and maybe one last letter that reflects what you mentioned, but a little bit more on a technical point— that’s always very interesting. So, that’s the 2018 letter it is another turning point because Warren Buffett decided to shift from a per share book value to a share price. So, if you could explain a bit the difference and why was that a better measurement of business performance?

Stefano Grasso

So, it’s a turning point and he has always been very ruthless about the market participants that changed the yardstick. So, he hates when manager changed the strike price of the stock option for the managing team. He hates when there are changing benchmark in investments because, you know, he says people are doing tricks. So, it was quite remarkable to see him finally giving in— in what was a measure that was not representative anymore of the value of Berkshire. He started using book value when the majority of the Berkshire Hathaway were listed company invested, I mean stocks, and observable numbers. So, it’s very easy to calculate the market price if you own a stock which is worth 100, your book value is 100. But the problem with time came because of the combination of two things:

One, Berkshire started buying more, bigger and bigger, more and more, you know, private companies. And therefore, there was a shift between what is traded and visible and what is the book value, so the acquisition price of the business. And these businesses you don’t mark up, you only mark down if there is an impairment, but you know, in the example of See’s candy probably they have on the book for a few million that they paid, and the business now is worth a multiple of that. But when you look at the Berkshire book value, you don’t see that example and you don’t see that transformation of the business. So, this shift between listed and private business is making the book value less and less relevant. And the second thing is an accounting rule— I think is from the 70s in the U.S.

When you buy a business, you often book a part of the purchase price as a goodwill. So is the difference between what are the hard asset of the company and the premium that as a buyer you pay to get ownership of the business. And the accounting rule wants to force you to write down this accounting goodwill—I think over a period of 30 or 40 years, so basically the longer you keep this business, the lower the book value, the more the book value is reduced. And, you know, companies like GEICO, the insurer. If you look at GEICO number when they took it private, the market share was like single digit in the United States and the revenues were a fraction of what they are today. So, the business clearly is worth 10’s of billions now, but the purchase value not only hasn’t increased, but has been reduced by the amortization of the goodwill.

So, in 2018, he kind of gave in and said, look, it’s not meaningful to report this number and it’s not really a fair comparison with the S&P 500. So, let’s switch to the share price, which is more volatile; that’s why he didn’t choose it before. But he says it’s more reflective of the true value of Berkshire Hathaway, of the intrinsic value of Berkshire Hathaway. And I think the 2018 letter in general is one of the last one where he goes into certain level of details of explaining certain concepts, so it’s another good one that I thought about flagging for reading.

Guillaume Roux-Chabert

Yeah, it’s quite a change, indeed, because I think he mentioned that he wishes he could not see the price of a share when he values a company, just not to be influenced by, you know, if it’s interesting or not to buy and you wanted to have it just like an intellectual process. So, that’s indeed a shift of thought for him even though he, of course, is value investing. So, moving forward, I’d like to ask you— What is for you the future of value investing and do you think it’s threatened by high frequency trading or liquidity crush or any other thing?

Stefano Grasso

I mean, you know, recently we read about this Chat GPT city fund that is basically, you know, run by Chat GPT, where they ask which stock to put in the portfolio and they’re tracking it. For the first few days, the news was that overperforming the S&P, but I think in terms of AI— maybe certain strategy will be probably interesting to implement, but for high frequency trading and liquidity, I think it’s actually an advantage.

You know, there are certain funds, an example is you know, we currently see the recession fear and certain commodity being sold and basically a lot of momentum funds going after these trends and following the trend. If you are a patient investor and you have an investment thesis that is correct, you basically have willing and heavy sellers that are going to sell your assets that you see as undervalued. So, if your time horizon is not like a week or a month or 1/4, but you think that the asset is undervalued for the next, you know, 3-5 years— then is when you can flip into an opportunity and really take advantage of that. So, I’m, I’m positive actually the impact of the high frequency and the liquidity on value investing.

Berkshire Hathaway Letters