Past Universe vs. Current Universe

In his 2008 annual letter for Berkshire Hathaway, Warren Buffett writes about the dangers of back-tested, historical results and formula-based investing:

“The type of fallacy involved in projecting loss experience from a universe of non-insured bonds onto a deceptively-similar universe in which many bonds are insured pops up in other areas of finance. ‘Back-tested’ models of many kinds are susceptible to this sort of error. Nevertheless, they are frequently touted in financial markets as guides to future action. (If merely looking up past financial data would tell you what the future holds, the Forbes 400 would consist of librarians.)

Indeed, the stupefying losses in mortgage-related securities came in large part because of flawed, history-based models used by salesmen, rating agencies and investors. These parties looked at loss experience over periods when home prices rose only moderately and speculation in houses was negligible. They then made this experience a yardstick for evaluating future losses. They blissfully ignored the fact that house prices had recently skyrocketed, loan practices had deteriorated and many buyers had opted for houses they couldn’t afford. In short, universe ‘past’ and universe ‘current’ had very different characteristics. But lenders, government and media largely failed to recognize this all-important fact. 

Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas.” 

The larger point is that the past universe for a particular investment, whether it’s a bond, stock, or some other type of financial instrument, may not be the current universe. The present situation may be fundamentally different than what’s generally prevailed in the past. If you invest in a way that doesn’t recognize or factor in this type of fundamental change, then your results may suffer.

If, for example, you don’t feel comfortable about a particular retail company’s ability to survive in today’s competitive landscape, then it probably shouldn’t be in your portfolio regardless of whether it looks quantitatively cheap. Prospects like these should probably go in what Buffett calls the “too hard” pile.

It seems like many value investors are buying groups of stocks that appear quantitatively undervalued but really should be avoided because the past universe is much different than the current universe. This may explain — at least in part — why these same investors have often underperformed the FAANG companies disrupting so many traditional businesses and industries. If the competitive landscape of a traditional business/industry has fundamentally changed, then past financial results may not matter much, making an apparent quantitative bargain illusory. In this situation value metrics drawn from past data may be misleading and unreliable, leaving the investor unable to intelligently predict or estimate whether: (1) an investment prospect will survive, and (2) what the prospect’s normalized earning power will be going forward. Funds invested in the face of these problems probably amount to speculation and guesswork rather than businesslike, Graham-style investment.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.

Buffett’s Favorite Themes

Low Cost and Size Advantages 

In Buffett’s annual letters certain themes keep popping up. One is that Buffett likes a low cost competitive advantage and another is that he likes it when sheer size confers a competitive advantage. A low cost example is GEICO. A large size example is reinsurance and Berkshire’s ability to insure and reinsure large risks that no one else can — this leads to huge amounts of investable float and often extraordinary underwriting profits.

Capital Intensity 

Buffett also likes capital intensive businesses when large amounts of incremental invested capital can be deployed at attractive rates of return. Berkshire invests huge amounts of incremental capital in utilities and railroads. Businesses like these often face little competition or inferior competition because of regulatory entry barriers and because most companies are reluctant to make these kinds of large investments. Berkshire’s access to abundant capital, and its willingness to freely deploy this capital when return rates are attractive, give it a competitive advantage in capital intensive businesses.

Great, Hard to Copy Products 

Finally, Buffett likes companies with unique, hard to copy, great products. These qualities lead to strong brands, high customer satisfaction rates, and high customer loyalty. This theme seems to drive Buffett’s investments in Coca-Cola, See’s Candies, Apple, and American Express. In his letters Buffett regularly refers to customer satisfaction metrics because these numbers measure loyalty and brand value.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice. 

Capital Allocation

In his annual letters Warren Buffett talks about the importance of capital allocation. Paraphrasing Buffett, when a company can invest its earnings in incremental assets at high rates of return it should do so, or it should use this money to acquire — in whole or in part — fairly priced “wonderful” companies generating attractive returns. When these options are unavailable, the company should return earnings to shareholders through share buybacks if the company is meaningfully undervalued, or though cash dividends if the company is fairly valued or overvalued.

Buffett says one of Berkshire Hathaway’s key advantages is its ability, as a conglomerate, to dispassionately invest capital in closely held and publicly traded companies across a range of industries. This kind of choice makes it easier for Berkshire to find fairly priced companies — to purchase in whole or in part — that are growing sales and earnings at high capital return rates. Additionally, Buffett doesn’t insist on operating control when looking for investing prospects — he’d rather own part of a great company than all of an average company. This gives Berkshire a flexibility advantage over companies that want control. Buffett also notes how easy it is for Berkshire to internally shift capital from a “cash cow” subsidiary that can’t invest retained earnings at attractive returns to a growing subsidiary that can.

Berkshire’s flexibility in deploying capital allows it to continue growing despite large sales and a large market capitalization. Most companies can’t invest capital in such a varied way: they operate in one business and one industry, resulting in fewer acquisition choices and fewer ways to shift money around internally. Limited choice often causes a company’s management to invest capital poorly, either by (1) expanding an existing, low capital return business or (2) making a controlling acquisition at a premium price.

Berkshire benefits not just from the varied ways it deploys capital, but from the large capital amounts it has to deploy. The company invests equity capital in the form of earnings generated by its subsidiaries, in addition to debt capital in the form of insurance float generated by subsidiaries like GEICO. Insurance float is the up-front premium money insurers hold/invest until these monies are paid out in claims. Berkshire invests float in attractively priced equities generating high capital returns. Float is a debt liability on the balance sheet, but Buffett believes this is a mischaracterization: he views Berkshire’s float as a costless, revolving fund — which Berkshire can invest in attractive equities — whereby claim payouts are continually replenished by insurance premiums. Through the years Berkshire’s insurance float has steadily grown, giving the company more and more money to invest. Buffett notes that returns from invested float are then augmented or reduced by underwriting profits or losses. When insurance premiums exceed expenses and eventual losses there’s an underwriting profit. When expenses and eventual losses exceed premiums there’s an underwriting loss. In most years Berkshire’s insurance subsidiaries have generated an underwriting profit. 

Companies shifting from growth to maturity often have trouble adjusting their capital allocation: they retain earnings for low return projects or acquisitions instead of distributing this money to shareholders through dividends or share repurchases. It takes managerial discipline for a company to forgo low return investments, even when these investments generate additional sales, earnings, and earnings per share. Low return investments waste retained earnings because shareholders could invest this money elsewhere at higher returns.

Poor capital allocation, industry competition, technological disruption, and business model disruption all cause declining returns and regression to industry mean returns. A company can delay and sometimes prevent declining capital returns through (1) shareholder-friendly capital allocation and (2) unique activities/strategy a la Michael Porter (e.g., Apple and Southwest Airlines). 

Buffett notes that shareholders of companies that allocate capital poorly actually pay twice: once via the earnings retained and invested by management at low returns, and once via the lower market value assigned to companies that behave this way. Smart capital allocation, whether it’s repurchasing shares at appropriate times or retaining earnings at appropriate times, may be the best quantitative indication of good management.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.

Forecasting, Breaking Questions Down, and Probabilities

I'm currently reading Superforecasters by Philip E. Tetlock and Dan Gardner (Crown Publishers, 2015). The book addresses how to improve forecasting accuracy. Two ways to do this are: (1) breaking difficult questions or predictions down into parts that can be answered or predicted more easily; and (2) assigning specific probabilities to different possible outcomes rather than simply defaulting to yes, no, or maybe (few people take time to think in terms of specific probabilities). Id.

If you're an investor these are helpful concepts to keep in mind. So an investor in Apple might have difficulty answering a question like "will Apple's earnings grow or at least stay flat over the next three to five years?", but this question becomes easier if you break it into parts:

  1. Will earnings from iPhone sales in the United States grow or at least stay flat over this time?
  2. Will earnings from iPhone sales in China grow or at least stay flat over this time?
  3. Will earnings from iPhone sales in India grow or at least stay flat over this time?
  4. Will earnings from iPhone sales in Brazil grow or at least stay flat over this time?
  5. Will collective earnings from iPad sales, Macs, and Apple Watches grow or at least stay flat over this time?
  6. Will Apple move downmarket as necessary to grow earnings in China, India, and Brazil? 

And so on . . .

You then assign a probability to each of these question subparts, digging for information that allows you to be as specific and granular as possible (e.g., a 63% estimate is better than a 60% or 70% estimate). 

Applying Superforecasters, Warren Buffett and Charlie Munger seem to follow a concentrated portfolio strategy so that they can carefully weigh the probability that each investment will succeed, thereby improving forecasting accuracy. This strategy would be impractical if Buffett and Munger diversified through a wide array of stocks -- too many holdings would make it difficult for them to carefully weigh each investment's probability of success, thereby hurting forecasting accuracy. This all dovetails with Buffett's famous quote that he'd rather be "certain of a good result [a high probability event] than hopeful of a great one [a 50/50 chance or worse]."

The author owns stock shares of Apple and Berkshire Hathaway.