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Some Thoughts on the Berkshire Hathaway Annual Meeting

I had a great time in Omaha this past weekend. I got to meet with a couple clients, reconnect with some like-minded value investors, and meet some new friends as well. And of course, being in the same building with two of the greatest investment minds in history is something special.

I wanted to make just a few comments on a couple things in my notes from the weekend. This is by no means a comprehensive summary—and there are many things of value that I’ll leave out. The post would be too long to cover everything I found interesting. So these are just a very select few things I thought I’d comment on as I was reviewing my notes this morning.

(Please note: When I am using quotes for Buffett and Munger comments—these are quotes from my notes as I was feverishly writing on scores of notebook pages all day. The quotes capture the gist of the topic and I believe they are mostly accurate, but may not be exactly verbatim at all times.)

On “Cost of Capital”

“I’ve never heard an intelligent discussion on cost of capital.” – Munger

This was an interesting discussion. And it also contained some classic Munger one-liners.

Both Buffett and Munger agreed that the term “cost of capital” is an abstract concept that is often used by CEO’s and CFO’s to justify investments or acquisitions (i.e. “We think this is “accretive” because the returns exceed our “cost of capital”). Buffett said he has sat in on thousands of these types of discussions where “the CEO has no idea what his cost of capital is” and “I don’t have any idea of what his cost of capital is either”.

Buffett and Munger had a much better way to view cost of capital that I thought was much simpler.

“Cost of capital is what could be produced by our 2nd best idea and our best idea has to beat it”.

Buffett went on to say that the “deal test is whether $1 we retain produces more than $1 in market value… not ‘cost of capital’”.

Classic Munger: “Cost of capital is stupid.” He went on to say that Warren’s test is the best way to view capital allocation and reinvestment opportunities within a business. “It’s simple: We’re right and they’re wrong”.

We’ve heard Buffett discuss this “$1 of value for $1 of retained earnings” test plenty of times, but it really helps to hear its common sense logic reiterated. Buffett said that they are “always thinking in terms of opportunity costs”. Thinking in this manner, rather than some model that can be manipulated in a spreadsheet, is a much more productive way to analyze investment opportunities within a business.

Munger once used this idea when referring to stock investments in general. He basically said that whenever they were looking at a stock, he would compare it to Wells Fargo. His thought process was: if it’s not a better value than Wells Fargo, then just buy more Wells Fargo.

I personally view “cost of capital” as similar to DCF models. They both use numbers that appear to be provide precise and accurate information but in reality can be easily manipulated to achieve the desired result.

Takeaway here: Set up a simple decision tree. Think in terms of simple opportunity costs. Look at whether a business is producing more than $1 of market value for every $1 retained—don’t use “cost of capital”.

See’s Candies

“See’s main contribution to Berkshire was ignorance removal.” – Munger

I don’t recall the specific question, but Buffett and Munger began talking about the early days of their investment philosophy evolution—specifically their newfound and developing interest in quality businesses that could produce high returns on capital and consistent free cash flow.

Munger said that “we were pretty stupid when we bought See’s” and in fact “we were just barely smart enough to buy it”. He is bluntly describing how they were willing to nearly walk away from See’s because of their unwillingness to pay up for the business. They of course did pay up (although from my calculations still were still buying it for a pretty low earnings multiple), and more importantly, they began learning about the power of this type of business (one that produces much more cash than is needed and one that can grow without sizable investments).

“I always understood brands, but there is nothing like owning one.” – Buffett

Munger said that if they didn’t buy See’s, there is a very good chance that they never would have bought Coke a decade and a half later. This demonstrates the power of compound knowledge. At first they had no interest in paying what seemed to be a premium for franchise businesses, but Munger convinced Buffett to buy See’s, and in the process of owning that investment they almost serendipitously discovered the power of a business model like See’s.

Munger describes this process as “ignorance removal”. It allowed them to remove their rigid focus on metrics and begin to view value in a much more comprehensive way, paving the way some of Berkshire’s most significant home runs and—perhaps more importantly—presumably reducing many would-be errors of commission.

On Circle of Competence

“If you just keep learning things, eventually something will work.” – Buffett

This was a classic Buffett teaching moment. He basically said that to develop a circle of competence he would do the same thing that he did when he was 23. He said he would look at lots of companies to learn about them.

He said that if he wanted to learn something about the coal industry, he would go around and talk to 8 or 9 coal executives, and ask them about their business models and their competitors. He implied that one can achieve an enormous amount of knowledge by talking to management and people who understand the industry better than you do.

On Intrinsic Value

“A bird in the hand is worth two in the bush”.

I had a reader ask me to define intrinsic value last week. I’ll let Buffett define it here, as he does in Berkshire’s owner’s manual:

“Intrinsic value is the present value of all cash that will be distributed from now until judgment day”.

We hear that definition a lot. Buffett said that intrinsic value has really become equated to the value that a private business value. It’s a relatively simple concept—how much cash will an owner receive from the business in the future? What is the present value of that future cash?

We are trying to determine: Are the two birds in the bush (future cash flow) worth more than the bird in the hand (the cash required to buy the business)?

He said that Graham would have focused on more quantitative aspects of a company to determine the future cash that could be withdrawn from the business. Conversely, Phil Fisher would have focused on more qualitative aspects to determine the same thing. He basically said that the objective is to lay out money now to receive more money back later. “That’s the point of a business”. Put cash in, get cash out. He said that Ben Graham and Phil Fisher would agree that the value of a business is based on this “cash in—cash out” idea.

He also implied that determining intrinsic value is an art form. He said that if he and Charlie were to write down their intrinsic value estimate of Berkshire, they would probably be within 5% but wouldn’t be within 1% of each other.

On Conglomerates and General Investments

“It’s not a bad business plan to own a bunch of great businesses.”

The question was related to conglomerates but Buffett and Munger used it as a way to espouse some of their general wisdom on investing in general.

They started by saying that most conglomerates fail because of financial engineering (issuing stock at 20x to buy at 10x—Buffett likened this process to a chain letter). This practice doesn’t create long term value. The key is to buy great businesses and focus on earning power, not engage in financial engineering.

Keys to successful conglomerates:

  • Common sense business principles
  • Good capital allocation
  • Focus on earning power, not stock promotion (issuing stock to make investments)

Buffett said that “our goal is to buy really good businesses that can grow over time and that have great managers”.

Charlie added that there are two main differences between Berkshire and the failed conglomerates:

  • We can buy stocks
  • We don’t feel the need to always be doing something

This last point is underrated. Berkshire doesn’t have to deal with limited partners who have expiring lock up periods (thus demanding shorter term results). They can sit on piles of cash as long as they want and wait for the proverbial “fat pitch”. This is incredibly valuable when things become distressed.

On Identifying Winning Businesses in “Disruptive” Times:

  • “We stick to businesses where we can identify the winners”. Buffett discussed his classic and simple idea that he likes to look for businesses where he can imagine the earnings being much higher 10 years from now.
  • He and Munger try to stick to businesses that have slow changing characteristics (likely will be providing the same basic product or service in 10 years that they are currently providing). He mentions that all businesses go through changes, but he tries to invest in ones where change is happening slowly and over time.

Final Thought

There were many other interesting topics broached during the 6 hour Q&A session. One book I added to my ever growing Amazon wish list is Dream Big by Cristiane Correa, which is about Jorge Paulo Lemann and 3G Capital, the firm Berkshire partnered with to buy Heinz. Buffett spoke very highly (and very often) on Saturday about 3G and how he believes they are incredibly talented managers.

As I continue perusing my notes, there are many other thoughts, but they’ll have to be reserved for future posts.

Have a great week!

11 thoughts on “Some Thoughts on the Berkshire Hathaway Annual Meeting

  1. Hi John, thanks for the post – full of great insights and notes.

    Could you share some more thoughts on the common sense way of approaching cost of capital? Would you look at the change in retained earnings yoy compared to the change in market cap – or perhaps an average? Capital projects take time to pay off and mr. market can be tempremental…perhaps a moving average is more appropriate? What about comprehensive income or minority interests?

    Sorry if these questions are elementary…things get a little bit more hairy when you start diving into actual financial statements!

    Much appreciated!

    1. Hi Alec, yeah I think Buffett’s definition of cost of capital is the best way to look at it. Basically the opportunity costs. I think his concept of thinking in terms of every dollar retained creating at least a dollar of market value is an excellent way to judge capital allocation. You could also use intrinsic value in place of market value, but over time my theory is that intrinsic value reflects market value. The easiest way to think about it is to think in broad terms like a business owner. The objective when retaining earnings is to create more value for the enterprise. There are various ways to judge that, but the simplest is the value it has created for shareholders. And as you say, this should be measured over a very long period, as yearly market prices fluctuate wildly above and below intrinsic value.

      Just remember the basic concept: every dollar retained should create at least a dollar in value for the owners.

      1. Hi John, I am not sure I fully understand this basic concept: Let’s assume a company has a constant P/B multiple of 1.0 and never pays a dividend. Then the increase in market cap over a certain period of time should equal the cumulative retained earnings over the same period, right? So, this company would pass the Buffett test. However, it could still destroy value for investors, namely if the ROI from the retained earnings is below the investors opportunity cost…am I not interpreting this correctly?

        1. Fabian, Yeah Buffett said at the meeting that he thinks of cost of capital in terms of “his best idea… and investment opportunity or capital allocation idea at hand has to beat his best idea”. So essentially he described it as opportunity cost. Not some arbitrary 9% or such things that you see corporate executives use.

          The retained earnings test I think is a good way to think about “cost of capital”. Buffett’s rule of thumb is that a dollar retained should create at least a dollar of value. So it’s a minimum hurdle. He’s not suggesting retaining earnings and letting cash pile up just because it might pass this test (as you say, that assumes the market continues to value the business at the same level, a dubious assumption if management isn’t reinvesting earnings and letting low earning cash pile up). In your example, as you say–if there are better uses of cash, then the best use of cash should be employed.

  2. excellent! the cost of capital is useless in fact. conservative managements can finance through retained earnings

  3. Thanks for the notes! Good to hear what Buffett and Munger are up to.

    I agree about the whole “cost of capital” thing. I don’t know many investors in real life, but I was talking with a B school student about cost of capital. I said I really had no idea what WACC was but I generally discount my own cash at mid 20 percent since those are the investments I find interesting. She told me that was a terrible discount factor. I suppose it is if you’re trying to raise capital. But for investment one is just trying to maximize returns so one just sorts all ideas by return. That’s way more intuitive than some formula that depends on different components of the capital structure and beta. That’s also pretty much what the Kelly formula gives too (although it divides by the variance of outcomes for each investment, and inverts a correlation matrix to try to de-correlate the investments).

    I can imagine business executives make all sorts of horrible capital allocation decisions because they don’t have simple rules of thumb like that. For example if I have a tech startup, I might think very low WACC is the best, because everyone wants to increase revenue through the roof without making a profit, and then IPO, so you want low cost of capital. Therefore, you might want to merge with an even more expensive tech startup to further lower the cost of capital. Obviously that sort of decision making could get really crazy :-).

  4. Thanks for notes. I, and may be few others, may never have heard about these interesting perspectives.

    I personally, liked the idea “He basically said that whenever they were looking at a stock, he would
    compare it to Wells Fargo”. I have been following the same strategy for a long term. Before buying a brand new stock, I compare it with other stocks in my portfolio and checks if it
    stock provides more value to me. In case it does not, I buy more of existing stock. I am glad that Buffet has said about it. It means; I can follow it with more vigor as I know it works.

    Thanks again for insightful notes.

  5. Regarding the quote “He basically said that whenever they were looking at a stock, he would compare it to Wells Fargo. His thought process was: if it’s not a better value than Wells Fargo, then just buy more Wells Fargo.”

    I hate to take this so literally, but if it is a better value than Wells Fargo, does that mean you should sell all your Wells Fargo for your new best idea?

    What I am getting at is that in practice, you don’t know. You don’t know with certainty if your new idea is better than Wells Fargo. But you may have some notion the likelihood that it is better than Wells Fargo. So you concentrate your portfolio accordingly based on your own view of the odds. Otherwise, you’d always only hold one stock that represents your “best idea”.

    1. Hi Gil,

      Yeah that’s a fair point. Kind of the idea of: “Well if you know your best idea, why not put all your capital into it?”…. I’m not sure how Buffett would answer, but as you say, there are no certainties in this game. You have to have some level of diversification to ensure that 1) your mistakes won’t hurt you permanently, and 2) you achieve your expected results.

      The concept is what is important here, not the exact number of positions and the literal interpretation.

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