Portfolio manager’s Letter May 2005
Saturday night after the Berkshire Hathaway annual meeting my wife and I were sitting in the bar at “The Drover” waiting for a table. The place is always packed the night after the AGM (they have a great whiskey rib eye). Two men came in and sat down next to us at the bar and started to converse in German. My wife is Russian and speaks English with a heavy accent, and when the man next to us heard the accent he asked where she was from, so we started a conversation, and ended up sharing a table for dinner.
It turns out that both of our new acquaintances were from Germany and were in Omaha to attend the Berkshire Hathaway Meeting. One was an employee of Der Spiegel, and was still living in Germany, but the other was a private equity manager living in London. This, of course, sparked my curiosity so I spent some time questioning him about Charlie Munger and Warren Buffett’s comments on private equity and hedge fund money. Somewhere during the course of the evening he made a statement to the effect that he knew quite a lot of people running private equity money in Europe and that they all followed Buffett’s philosophy.
He explained that private equity is primarily institutional money, pension plans, education institutions such as Harvard or Oxford, together with some ultra rich individuals, and that most of the managers had appeared in the last three or four years. So, not only are stocks in general over valued, but there are big piles of money chasing those asset classes that are popular with value investors. The reason that Berkshire Hathaway has not been able to buy much in the way of whole businesses in the last three or four years is that there are large pools of money out there bidding up the price of everything that comes down the pike.
Times have changed dramatically in the fourteen years since I attended my first Berkshire Hathaway annual meeting. In 1991 if I told people I had been to the Berkshire Hathaway meeting, I would just get this strange blank look, and the unstated question, “Who the hell is Warren Buffett?” Today it seems that everyone has heard of Warren Buffett.
My circle of competence may be limited, but there is one thing I have learned through 38 years of investing: the market will always do what it has to do to prove the majority wrong. Or as Buffett says, you pay a high price for a cheery consensus. This is not because the market is perverse, but because the market is a zero-sum game and frictional costs mean that there will always be more losers than winners.
For most of his life Warren Buffett has been able to play on a field were all the big money was doing something else. In the eighties and nineties the big money was in mutual funds, and all they wanted was growth stocks. Eventually the popularity of this class drove their prices up and their risk level into the stratosphere. At first Warren Buffett was just obscure, but even as he became better known, for Wall Street he was a six sigma event and no one was much interested in following his philosophy. But in the last five years, since the growth bubble pop, things have changed some.
So what happens to us if value investing becomes the cheery consensus? Depressing as this line of thought is, it is clearly the direction that we are headed. In 1991 there were 1500 people at the annual meeting. This year it was something like 20,000. Great as this is for the hospitality industry in Omaha, I am not sure that a similar benefit will accrue to people of the value-investing faith. Maybe this is what Charlie is thinking about when he says that they may have to lower our expectations? Maybe this is what has driven Warren Buffett to buy S&P puts, junk bonds, and foreign currency?
On a more positive note, this is clearly something Warren Buffett has thought a lot about and his take at the annual meeting was that he may get crowded out for a while, but that things can change in a hurry. He sited the junk bond market in 2002 as example were he was able to put nine billion to work in a short period of time. Still this opportunity did not last very long.
Charlie said that he does not expect to see another 1974. A careful review of Warren Buffett’s comments at the meeting reveal that he may not total agree with Charlie on this point, but who can tell which one is correct. Warren Buffett, the optimist, believes that there will be a market crash, were Charlie Munger, the pessimist, disagrees.
For smaller investors there is always micro cap as an area where anyone managing serious money cannot play, because if you are managing $100 million or more, it is hard to buy a significant piece of a company with a $250 million market cap. But even this area may get difficult because if a good company gets cheep enough, a private equity manager may come along and buy the whole thing and take it private.
So do I think that value investing no longer applies? Of course not. But I do think it likely that barring a real nice crash in the equity markets, the next few years will be difficult. For the last five years you had to outperform the market by 8% to get a net return of plus 4.5%. This is not my idea of easy pickings, and while it may be quite satisfactory for the true value investor, an investor paying two plus twenty is not likely to be happy with an annual return of 4.5%.
In support of Warren Buffett’s optimism (that there will be a crash) is this fee structure of the hedge funds and the private capital. A twenty percent carrot offers a very strong incentive for intelligent managers to do stupid things and for the not-so-intelligent, it is certain to generate all sorts of bad behavior. It is particularly interesting that while Warren Buffett has been doing practically nothing for the last three years, many of the private equity managers who profess to follow his value investing principals are buying things that Warren Buffett would not buy. Or, at least at prices he would not pay.
With close to a billion in equity and another billion in leverage, one thing seems certain: hedge funds as a class will not be able to outperform the market. It is reported that there are now 8,000 hedge funds competing for market-beating returns, but the amount of money managers in the universe that have the discipline, intelligence, and experience to beat the market is far short of this number. I personally would be greatly surprised if there are 800.
I have no idea how much money is in the hands of private equity managers, but it would not surprise me that they are now in the same position as the hedge funds(too much cash in a class for it to outperform the market). Perhaps what Warren Buffett sees is a huge amount of hot money with nervous feet. Hopefully enough to cause a stampede of the “electronic herd” of sufficient magnitude of allow him to spend $45 billion.
On Charlie Munger’s side of the argument are the large cash positions in value funds and the large short positions by the hedge funds, for if there is a cheery consensus for a crash, then it probably will not happen.