Nostradoofus

Here are my notes from the Wesco Financial annual meeting of shareholders on May 9, 2007. I am paraphrasing Wesco chairman (Berkshire Hathaway vice-chairman) Charlie Munger — there are few direct quotes here.

Why was Berkshire Hathaway a “lollapalooza”? (Charlie Munger’s word) It was multiple factors acting in concert, reinforcing one another:

• Warren Buffett is smart, though not the smartest.
• He was extremely interested in investing from age 10. Hard to excel in a subject if you’re not intrinsically fascinated.
• To start early in professional life is a tremendous advantage.
• Buffett is one of the best “learning machines.” Consistent, lifelong learning.
• In investing, accumulated wisdom doesn’t decay rapidly in value (contrast this with technical disciplines such as software).
• All the work of Berkshire was concentrated in one man’s mind. As with Singapore under Lee Kwan Yew, one excellent individual drove the entire enterprise to victory.
• Buffett has a habit of maximizing his objectivity.
• He received constant rewards for doing well. This has the effect that behavioral conditioning would predict: he continued to improve. Contrast this with normal corporate pay, which rewards a CEO no matter what he does.
• Buffett is not influenced by “nuttiness”: envy, greed, profligacy, revenge, self-pity, “world is unfair to me,” etc.
• He is more like Marcus Aurelius: a tough stretch is, for him, an opportunity to learn, teach, etc.

“You could argue I was forced into investing, because one is rendered a social outcast in most fields by calling revered luminaries “nuts.”

There is a great difference between intelligence and judgment. Having one implies nothing about whether one may have the other.

• For example, by basic good judgment, it’s obvious that trust is more important than compliance. Any contractual clause you may write in can be trumped by an untrustworthy counterparty. Yet many otherwise intelligent people don’t value trust highly enough in their business dealings. By contrast, we (Wesco Financial) didn’t even do audits until the outside world forced it upon us. Instead, we dealt only with people we trusted.
• For example, avoiding conflict of interest is more important than being current in your books. If you mark derivative instruments to market, for example, you leave valuation in the hands of internal people with a strong incentive to overestimate their value. Thus being current creates a conflict of interest, and thus obviously should not be done. Even senior accountants don’t understand this.

“Posco is not a commodity business.” — technology advantages were learned from Nippon Steel that give them an edge. But don’t write off commodities entirely — even they are attractive at some price.

“We don’t play gin rummy with our friends.” (meaning that Berkshire only buys businesses to keep, not to resell.)

• This reputation attracts better businesses — companies that would sell to no one but Berkshire.
• By contrast, because private equity buys to flip, they cannot get access to the quality of deals we do.

Envy is driving endowments to throw money into private equity. To see what will happen, observe what happened in to endowment investments in venture capital a few years ago.

USG made a mistake to do a rights offering in summer 2006 at well below intrinsic value.

Useful mental model: inversion. For examle, instead of “what do I want, and how do I get it,” also consider “What do I dislike, and how do I avoid it?”

Investor question: “what long-held belief have you changed recently?” Munger’s answer: We changed a lifelong belief about railroads recently. Why? Because of the recent comparative advantage of railroads over trucking. Rail improved with double-stacked trailers, computer scheduling, and rising real energy costs.

Book recommendations:

• “Martians of Science”
• “Deep Simplicity”
• Isaacson’s biography of Einstein
• Supermoney (decades old, but worthwhile)

Two kinds of market inefficiency these days:

• Too small for anyone to follow it.
• Craziness in bigger markets, e.g. panics.

Two markets in China:

• Gross excess in Shanghai
• A few interesting things elsewhere. Hong Kong is still pretty inefficient.

Treasury Secretary Nicholas Brady reversed his decision to cut off Salomon Brothers from government bond auctions based essentially on his trust of Buffett and his reputation.

Munger bought his first new car at age 60, long after he had become very wealthy.

Much trouble traces to “self-serving bias.” Plus envy.

Think of investing in terms of opportunity cost, not hurdle rate.

Lessons of the past 10 years — more of the same:

• Be more selective.
• No regret at passing up immoral investments, e.g. chewing tobacco.
• Don’t let envy drive investment decisions.

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The highest investment return I have ever achieved was not on a stock, bond or business investment.

It was to replace my home thermostat.

My home was built in 1977. Almost exactly 30 years later, in March 2007, I updated to a modern programmable digital thermostat, which cost $40 plus a half hour of installation time, using only a screwdriver.

In the first 8 weeks, our gas use fell by more than half compared to last year, despite colder weather this year. The savings are at least $150. Summer air conditioning results remain to be measured, but the implication is we will save between $500 and $1500 in the first year, on a $40 investment.

This can happen because programmable thermostats are flexible. By day, you want the temperature at 67 degrees, but at night, no one cares if it falls to 62. That 5-degree change causes a nonlinear reduction in energy use — depending on outside temperature, it can be the difference between running the heater 10% of the time or 100% of the time at night.

Whether you value energy conservation or frugality, this is an astonishing result. The implication is that, if you have an old house, you can save more energy with a $40 thermostat upgrade than by buying a $20,000 Toyota Prius.

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You can exploit inefficiency in non-equity markets, of course. Here is a way to get screaming bargains on used kayaks from craigslist.

I wrote this Ruby port of Jeremy Zawodny’s similar Perl script. It runs every 20 minutes, notifying me by email of new postings likely to interest me.

The result is effective, but potentially creepy: you post an item on Craigslist, and your phone rings 5 minutes later with my offer to buy. This freaks a few people out.

Using this method, I bought a nearly new $1500 sea kayak for $600, and a well-maintained $1200 Stairmaster for $200. Beneficial deflation in action.

(You could do this with an RSS reader, as craigslist can publish your search as a feed. But I always forget to check RSS. By contrast, nothing shakes you by the lapels like an incoming email saying, “bargain here.”)

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“What is the value per hour of what I’m doing at this moment?”

“Value” doesn’t necessarily mean money. The point is that, beyond financial planning, return on investment is an organizing principle.

When you are able to answer the above question accurately at any time during your workday, you understand time management deeply. You know which parts of your day generate most of the value — often ten, a hundred, even a thousand times the value of your least valuable moments.

I said “accurately,” not “precisely.” Precision doesn’t matter. Nor do the units on your yardstick: they can be dollars, fun, self-improvement — whatever is important.

Armed with this knowledge, changes automatically suggest themselves. If, at that point, you are still busy, it’s generally by choice.

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Mr. Bogle, don’t take this the wrong way. Index funds are a great invention: they are simple, tax efficient, perform well, and push down investment management fees generally. All of these things benefit individual investors.

“Parasite” refers only to the fact that index funds benefit from market efficiency, while providing none.

Index funds track an overall market index by maintaining an appropriately weighted portfolio that mirrors the index. This performs well by riding the rising tide of the general stock market at very low cost.

But imagine if all equity capital were invested through index funds. Then index funds would comprise the entire market. No mechanism would exist for buying stocks below intrinsic value, and selling above intrinsic value. Markets would not be efficient, and stocks would follow a path that bore no relationship to value.

That imaginary situation cannot occur, because in the real world, “value arbitrageurs” always step in to restore market efficiency. But the fact is that index funds are nonmarket entities. Realistically, as index funds take an ever larger fraction of total market capitalization, a market distortion might begin to appear in the form of increased volatility.

Investors extrapolate. Thus, when markets have gone up recently, they pile into index funds, which then automatically buy stocks without regard to price. If this is done in sufficient volume, stock prices generally will rise to historically unusual price/earnings ratios. This creates a self-reinforcing state: rising stocks cause rising index investments, which cause rising stocks.

But individual investors also fear loss more than they desire gain. Thus, when a general market decline begins, redemptions accelerate. If index funds accounted for a large percentage of all stocks, and if price-earnings ratios were at historically high levels, then such a decline/redemption cycle could also be self-reinforcing. “Self-reinforcing decline/redemption cycle” is a very polite way of describing a market crash.

But that can’t happen, the efficient market theorist might argue, because the remaining non-index investors will simply arbitrage all that out, restoring efficient pricing. OK, let’s assume the theorist is right there. In that situation, who makes all the money? Hint: it’s not the index fund investor. Suddenly, they are on the wrong side of the efficiency equation. The arbitrageur makes the money by betting against the blind money going into or out of the market.

Thus it seems two things are true. First, index funds cannot grow past a certain point without ceasing to perform as they have. The change seems likely to emerge not as lower total returns, but rather as much higher volatility.

Second, for index funds to work, a mechanism of market efficiency must exist in the form of managed investments. That role might be small — perhaps only 10% of total market capitalization — but it must exist. And the larger the fraction of total capital under index fund management, the greater and more likely the distortion, and thus the higher the potential returns to traditional managed investments would become.

Thus, in the long run, index funds may actually benefit the few that remain as traditional investment managers.
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Computer-driven stock selection began in the late 1960s, most notably with Ed Thorp’s firm, Convertible Hedge Associates. Thorp applied information theory principles to portfolio allocation, and sought simple convergence plays, e.g. warrants underpriced relative to underlying stock.

The 1970s were a heyday for such strategies. Small but systematic market inefficiencies lurked everywhere. Computers were not widely available, so the few who had access and capability were at an advantage.

By the mid-1990s, most such opportunities had been competed away as understanding became widespread. But the democratization of data and computation was not finished.

By 2000, a small fund could afford fundamental and other data from specialized services like Compustat ($12,000/yr).

By 2002, an individual could obtain reasonably accurate U.S. company and stock data from free services like MSN Money. One could also filter the data set for free, to find all companies fitting a particular profile.

In 2006, these capabilities were spreading to worldwide markets, beginning with London.

It’s reasonable to assume that, very soon, investment managers will have no information advantage in terms of data and screening capability. It will all be instant and free, for everyone.

What’s left? Plenty. As always, strategy — defined as the profit that remains when your competitors execute perfectly — provides the direction.

Financial industry structure always forces a short-term bias. Because clients can pull their money out any time, there is irresistible pressure for investment managers to focus on short-term gain. This is a competitive inflexibility shared by almost the entire investment management industry. As a result, long-term strategies are likely to retain a larger advantage, for longer, than any other strategy.

Short-term bias forces non-fundamental strategies. When a fund manager is under pressure to hang onto clients by delivering an extra 100 basis points this month, he has no time to wait for intrinsic value to be recognized. That can take months or years, and he’ll be fired or out of business by then. So his effort inevitably goes to strategies that attempt non-fundamental strategies, those that try to guess short-term price movements. Individual investors tend to do the same, simply due to impatience. Thus intrinsic value strategies are less competitively exposed.

Index funds are a non-fundamental strategy. Index funds simply buy everything — they do not have the flexibility to stay out. Again, intrinsic value strategies are less competitively exposed.

Non-fundamental strategies are destabilizing in aggregate. Relative-price investment schemes — those that buy or sell based on a stock’s price relative to other stocks — are popular, yet distorting and destabilizing in the aggregate. This definition emphatically does include index funds. Since such “investors” are simply reacting to one another, trends are amplified. This is the reason stock prices are not normally distributed (the “fat tails” distribution problem). It is the source of bubbles and panics, and will always create opportunity for the investor that makes decisions only based on price relative to intrinsic value.

In summary, what’s left is intrinsic value, always intrinsic value. If it says to stay out of the market altogether, then so be it. But that won’t always be true.

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I noticed something interesting on the way to work this morning — a new handpainted sign reading, “Trapped in a 1% mortgage? Call 555-5555.”

For the second quarter of 2006, California mortgage defaults were up nearly 70% over 2005. The default rate doubled in San Diego and Riverside counties, as well as in Northern California excluding the Bay Area.

In previous regional real estate downturns, default rates typically don’t spike until well after prices peak. Hopeful homeowners hang on as long as they can, making payments and listing their properties for sale. As a result, normally, a real estate bust follows the slow timetable now playing out in Florida. But out here in California, lending practices from the past several years may serve to accelerate a downturn.

The big difference is teaser rate mortgages, in which a homebuyer pays only 1% for a couple of years, after which the rate resets to a variable based on short-term US rates. Because the Fed has raised rates so much, the reset can cause the homeowner’s mortgage payment to abruptly double (or more). Finance types have speculated for some time that teaser-rate mortgages might accelerate defaults in a downturn. Now it appears actually to be happening.

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I generally don’t sell stocks short, due to unlimited downside and exposure to speculative bubbles. You can be right in the long run, yet get killed by a margin call in the short run.

That said, if I were to sell something short now, it would be the entire state of Florida.

Regional real estate wipeouts all tend to repeat a certain trajectory:

1. Buyers vanish, but sellers are unwilling to drop prices.
2. Consequently, the number of sales collapses.
3. A year or two goes by.
4. Sellers start giving up and reduce asking prices.
5. Buyers see prices falling, and decide to wait it out.
6. Sellers are forced to reduce prices further.
7. If seller’s equity falls below zero, they stop paying mortgages.
8. Bad loans proliferate.
9. Banks with geographically concentrated loan portfolios start going broke.

This has happened several times in regional markets in the U.S. — Houston is the most flamboyant example of the last 30 years.

In Florida, we have arrived at Step 2 (see above) with the recent report that the number of sales in Broward County in south Florida has fallen 34% from last year. Median price fell less than 1% — we’re now waiting to complete Step 3.

This problem may extend to other states as well. But Florida looks particularly bad, because:

• The state’s economy is unusually dependent upon real estate.
• There exist many vacation communities with little or no underlying economy.
• Rampant speculation, including the infamous CondoFlip.com.
• Prices rise at 30% per annum from 2000 to 2005.
• Insurers flee the state on fears giant hurricanes will be common.
• Even Bush’s EPA puts south Florida under water in 100 years.
• South Florida will suddenly run out of water within 20 years, as seawater invades the aquifer supplying most of its drinking water.

Now, it’s possible Miami will become a charming, windblown Venice, connected to the mainland by a 100-mile, hurricane-proof causeway, giant desalination plants humming 24/7. Then again, I wouldn’t bet my own money on that.

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VC investment in GPL projects. The very idea recalls an old military saying about the F-14 Tomcat (or, some claim, the F-4 Phantom): “America’s proof that given a big enough engine, even a brick can fly.”

Certain GPL investments similarly remain commercially airborne with immense investor thrust behind them. But this will be unusual, and the main result will simply be to consume a lot of fuel. Software has been so successful for VCs for so long that it’s taking an inordinately long time for them to recognize the sea change: GPL closes down the old opportunities in software, and creates new opportunities that are not in software, at least not directly. Why? Basic microeconomics, and basic Michael Porter.

Software investments traditionally generate returns in two possible ways. First, you can create high customer switching costs through software complexity and/or ownership of proprietary interchange formats. Second, if you can capture enough of the market to permit enormous fixed investment in your source base, outspending any other potential entrant — economies of scale.

GPL does away with both of these possibilities. Economies of scale become impossible, because your fixed investment is automatically shared for free, no matter how large. Switching costs become nearly zero, because file formats and feature sets are no longer proprietary. In both cases, no matter how big you get, any 15-year-old in his bedroom can download your source code and compete with you.

This does not eliminate market power, it just moves it around. Anybody in the business of selling licensed software (Microsoft, Oracle, etc.) is in decline. They can’t possibly compete with a price of zero — all they can do is slow down the transition through FUD and customer relationships. Over time, all such product business will turn into service businesses.

But the biggest companies can mine their patents. A likely endpoint for Microsoft, 15 years from now, is as a seller of services and a licensor of its vast patent library. How large that business may be is not knowable.

And users of open source will thrive, when they can set up switching costs that are not related to the software itself. Google, eBay and Amazon all have this quality.

Nothing in this article should be construed as yet another dull argument about who is evil and who isn’t. I happen to think Google may become a larger, more powerful monopoly than Microsoft at its peak. That is not to say Google or Microsoft are good or bad — I’ll leave the moralization to the guys at Slashdot, because they’re so good at it.

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If you reduce the supply of something, the price goes up. The more successfully the US destroys coca crops, the higher the price goes, and the greater the incentive for tropical farmers everywhere to simply grow more.

If you instead reduce demand, the price goes down. The more successfully the US reduces coca demand (whether by moral suasion, education, re-education, imprisonment, testing, etc), the lower the price goes, and the less the incentive to grow, refine and distribute it.

If you focus on demand reduction, you also:

1. Starve bad guys of profits.
2. Automatically reduce a variety of related domestic social problems.
3. Reduce the incentive for corruption of US officials.
4. Stabilize Mexico’s border regions, reducing violent crime in the US.
5. Become a model of self-restraint, worthy of self-respect and the respect of other nations.
6. Save money. Projecting military power is immensely expensive — much more than fixing domestic problems.

Supply reduction accomplishes none of these. Microeconomically, the 20-year “war on drugs” is not only a failure — it is a surprisingly dumb idea.

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