Investment Manager’s Letter June 2001
Charlie Munger introduced the concept of “Sit on your ass investing” at the 2000 Berkshire Hathaway Annual meeting. The essence of his new school of investment theory is to find a few outstanding companies, buy them, and hold them forever. You should only buy a stock if you are not willing to hold for ten years, and if you are willing to commit a substantial portion of your money to it. But is it an investing style well suited to present markets?
Put another way, the Question is, If we want to outperform the market in next ten years is it best to just buy and hold, or if indeed the lean years are back, do we need a more aggressive plan. My, as investment manager, guess is that what has worked for the last ten years will not work for the next ten years. This long and very boring Letter is my attempt to explain my reasons for this opinion.
Bear markets are about changing behavior
My, as investment manager, first point is that I do not see that we are on the threshold of new long-term bull market similar to the one that lasted throughout the 1990’s. While the recent bear market may have ended because the FED has decided to pump up the money supply. Behavior has not changed enough. Bear markets are about changing behavior. Granted the tech bubble has popped and Wall Street is no longer pouring money into Internet and Telecom stocks. But many underlying structural problems that gave birth to these bubbles remain, and that could force Allen to slam on the brakes again about the time the market is able to work up a good head of steam.
There is still a huge concentration of capital in the hands of Mutual Funds and Hedge Funds. The existence of these large concentrated pools of capital means that good quality large cap stocks are still spectacularly overvalued. These are not conditions that favor the “Sit on your Ass”. Can you say “Nifty Fifty”?
Accounting games are still the rule, not the exception. The most significant of these games, stock options, is bomb that will go off some day, the only thing we do not know, is when.
Rules enacted in the 1980’s to discourage hostel takeovers now tend to isolate company Management from attack. Instead of serving shareholder interest they do the opposite, by protecting the incompetent CEOs, and locking capital and assets in unproductive uses.
Most of all, there is simply a lot more capital sloshing around than there are good investment opportunities.
Fat years – lean years
The Warren Buffett’s 1999 Fortune article divided the recent market history into 17 lean and 17 Fat years. It describes the period from 1965 to 1982 as a period of flat returns because in summer of 1982 the Dow was at about the same palace that was in summer of 1966. While this description is accurate it does not gives us any idea what it was like to own stocks during that period while the Dow ended the period about were it begin it. The ride was anything but flat. It consisted of a Series of four brutal bear markets brought on by Fed tightening to fight inflation. These bear markets were separated by weak bull rallies that lasted one to two years but petered out as stocks reached their old highs.
Warren Buffett warns that we should expect returns averaging 6% or 7% over the next ten years for the over all market. But does that mean 6% percent per year every year, or plus 18% this year and Minus 12% next year. I, as investment manager, would like to suggest a scenario were the next ten years will be more like the seventies than the nineties. Under this script there would be a succession of bear markets brought on by The Federal reserve action to deal with long term problems. These Bear markets will be separated by periods of one or two years of monetary expansion and market rallies.
If indeed, we were to follow this script, then let’s fit the last four years over the top of the late 1960’s and it looks like we have already moved past the first two waves. With August and September of 1998 being an imitation of the quick V dip of the market in 1966. The acceptance of this premise would place us now somewhere in 1970 at the beginning of the recovery from the second, longer, bear leg. Don’t get completely sucked in by this recovery though, because a couple of years further down this road is the really big bear of 1973 – 1974.
Of coarse we all know that markets do not follow scripts, but who knows, and there are some interesting parallels. Now, before you run to Walgreens for a three supply of Prosac, let’s get to what for me, is the bottom line of this post.
Warren Buffett’s results 1966-1982
So what was Warren Buffett doing during 1970s? Despite a market that was playing roller coaster Berkshire Hathaway was just going up. Check this by reading the per share book value chart that precedes the Chairman’s Letter in the annual report. From 1966 through 1982 a period in which The Dow went nowhere, Berkshire Hathaway’s book value increased by an average of 23% per year (Warren Buffett won the 17-year period 391% to zip). The most remarkable thing is there were no down years for Berkshire Hathaway during the entire 17 years while the S&P had six.
My, as investment manager, guess is Warren Buffett did not accomplish this by “sitting on his ass”. We do not have a good trail of Warren Buffett’s behavior during this period because the chairman’s letters are only available since 1977, but if we look at what is available in the Letters from 1977 – 1985 we see behavior very much in the traditional Value investor – Ben Graham pattern. Buying stocks when they are undervalued and selling them when they approach full value. Rarely were positions held more than a year or two.
I, as investment manager, do not find many buy-hold stocks today. The good stuff is still too expensive (with the exception of Berkshire Hathaway and maybe Costco). In the mean time my small and mid cap value stocks have been going up nicely.