Warren Buffett

The Inner vs. Outer Scorecard

Inner-Scorecard-v2.jpg

We all have egos in the psychological sense – defined as “a person’s sense of self-esteem or self-importance.” It’s the degree that denotes the positive or negative association that’s often attached to the term “ego.” There are two passages below, one from Howard Marks and the other from Warren Buffett, that share a common denominator: the role of ego upon an individual’s investment philosophy & decisions.

Howard Marks (The Most Important Thing, Chapter 10):

“…thoughtful investors can toil in obscurity, achieving solid gains in the good years and losing less than others in the bad. They avoid sharing in the riskiest behavior because they’re so aware of how much they don’t know and because they have their egos in check. This, in my opinion, is the greatest formula for long-term wealth creation – but it doesn’t provide much ego gratification in the short-term. It’s just not that glamorous to follow a path that emphasizes humility, prudence, and risk control. Of course, investing shouldn’t be about glamour, but often it is.”

Warren Buffett (The Snowball, Chapter 3):

“The big question about how people behave is whether they’ve got an Inner Scorecard or an Outer Scorecard. It helps if you can be satisfied with an Inner Scorecard. I always posed it this way. I say: ‘Lookit. Would you rather be the world’s greatest lover, but have everyone think you’re the world’s worst lover? Or would you rather be the world’s worst lover but have everyone think you’re the world’s greatest lover?’ Now that’s an interesting question.

Here’s another one. If the world couldn’t see your results, would you rather be thought of as the world’s greatest investor but in reality have the world’s worst record? Or be thought of as the world’s worst investor when you were actually the best?

In teaching your kids, I think the lesson they’re learning at a very, very early age is what their parents put the emphasis on. If all the emphasis is on what the world’s going to think about you, forgetting about how you really behave, you’ll end up with an Outer Scorecard. Now, my dad: He was a hundred percent Inner Scorecard guy.

He was really a maverick. But he wasn’t a maverick for the sake of being a maverick. He just didn’t care what other people thought. My dad taught me how life should be lived…”

Also, notice Marks’ statement that the best method of wealth creation is capturing portfolio return (volatility) asymmetry: “solid gains in the good years [compounding] and losing less than others [capital preservation] in the bad.” I think Buffett would agree with this approach - see Buffett 1966 Part 1 article. 

 

A Little Bit of History Repeating

Buffett-1980s.jpg

In 1977, Warren Buffett wrote an article for Fortune Magazine titled “How Inflation Swindles the Equity Investor.” In the article, Buffett outlines the parallels between equities and bonds, and the impact of interest rates & inflation movements on both asset classes.

Given the interest rate and inflation debate raging today, I thought it worthwhile to revisit and study what had transpired in the past.

Interestingly, if we applied the lessons of this 1977 article to today's environment, contrary to the article’s title, it actually bodes well for future equity prices (see bold below), especially those companies compounding and reinvesting earnings rather than paying dividends.

Inflation, Duration, Compounding, Opportunity Cost

“It is no longer a secret that stocks, like bonds, do poorly in an inflationary environment…When the value of the dollar deteriorates month after month, a security with income and principal payments denominated in those dollars isn’t going to be a big winner…For many years, the conventional wisdom insisted that stocks were a hedge against inflation. The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are, but represent ownership of companies with productive facilities…

…I believe…that stocks, in economic substances, are really very similar to bonds. I know that this belief will seem eccentric to many investors. They will immediately observe that the return on a bond (the coupon) is fixed, while the return on equity investment (the company’s earnings) can vary substantially from one year to another. True enough. But anyone who examines the aggregate returns that have been earned by companies during the postwar years will discover something extraordinary: the returns on equity have in fact no varied much at all…in the aggregate, the return on book value tends to keep coming back to a level around 12 percent. It shows no signs of exceeding that level significantly in inflationary years…

For the moment, let’s think of those companies, not as listed stocks, but as productive enterprises. Let’s also assume that the owners of those enterprises had acquired them at book value. In that case, their own return would have been around 12 percent too. And because the return has been so consistent, it seems reasonable to think of it as an ‘equity coupon’…

Of course, there are some important differences between the bond and stock forms. For openers, bonds eventually come due. It may require a long wait, but eventually the bond investor gets to renegotiate the terms of his contract. If current and prospective rates of inflation make his old coupon look inadequate, the can refuse to play further unless coupons currently being offered rekindle his interest…

Stocks on the other hand, are perpetual. They have a maturity date of infinity. Investors in stocks are stuck with whatever return corporate America happens to earn. If corporate America is destined to earn 12 percent, then that is the level investors must learn to live with. As a group, stock investors can neither opt out nor renegotiate…Individual companies can be sold or liquidated and corporations can repurchase their own shares; on the balance however, new equity flotations and retained earnings that the equity capital locked up in the corporate system will increase.

So, score one for the bond form. Bond coupons eventually will be renegotiated; equity ‘coupons’ won’t…

There is another major difference between the garden variety of bond and or new exotic 12 percent ‘equity bond’ that comes to the Wall Street costume ball dressed in a stock certificate.

In the usual case, a bond investor receives his entire coupon in cash and is left to reinvest it as best he can. Our stock investor’s equity coupon, in contrast, is partially retained by the company and is reinvested at whatever rates the company happens to be earning. In other words, going back to our corporate universe, part of the 12 percent earned annually is paid out in dividends and the balance is put right back into the universe to earn 12 percent also.”

Here is where things get interesting: 

This characteristic of stocks – the reinvestment of part of the coupon – can be good or bad news, depending on the relative attractiveness of that 12 percent. The news was very good indeed in, the 1950’s and early 1960’s. With bonds yielding only 3 or 4 percent, the right to reinvest automatically a portion of the equity coupon at 12 percent was of enormous value. Note that investors could not just invest their own money and get that 12 percent return. Stock prices in this period raged far above book value…You can’t pay far above par for a 12 percent bond and earn 12 percent for yourself.

But on their retained earnings, investors could earn 12 percent. In effect, earnings retention allowed investors to buy at book value part of an enterprise that, in the economic environment then existing, was worth a great deal more than book value.

It was a situation that left very little to be said for cash dividends and a lot to be said for earnings retention. Indeed, the more money that investors thought likely to be reinvested at the 12 percent rate, the more valuable they considered their reinvestment privilege, and the more they were willing to pay for it…

If, during this period, a high-grade, noncallable, long-term bond with a 12 percent coupon had existed, it would have sold far above par. And if it were a bond with a further unusual characteristic – which was that most of the coupon payments could be automatically reinvested at par in similar bonds – the issue would have commanded an even greater premium. In essence, growth stocks retaining most of their earnings represented just such a security. When their reinvestment rate on the added equity capital was 12 percent while interest rates generally were around 4 percent, investors became very happy – and, of course, they paid happy prices.

Looking back, stock investors can think of themselves in the 1946-1956 period as having been ladled a truly bountiful triple dip. First, they were the beneficiaries of an underlying corporate return on equity that was far above prevailing interest rates. Second, a significant portion of that return was reinvested for them at rates that were otherwise unattainable. And third, they were afforded an escalating appraisal of underlying equity capital as the first two benefits became widely recognized. This third dip meant that, on top of the basic 12 percent or so earned by corporations on their equity capital, investors were receiving a bonus as the Dow Jones Industrials increased in price from 138 percent book value in 1946 to 220 percent in 1966…

This heaven-on-earth situation finally was ‘discovered’ in the mid-1960’s by many major investing institutions. But just as these financial elephants began trampling on one another in their rush to equities, we entered an era of accelerating inflation and higher interest rates. Quite logically, the marking-up process began to reverse itself. Rising interest rates ruthlessly reduced the value of all existing fixed coupon investments. And as long-term corporate bond rates began moving up (eventually reaching the 10 percent area), both the equity return of 12 percent and the reinvestment ‘privilege’ began to look different.

Stocks are quite properly though of as riskier than bonds…they come equipped with infinite maturities. (Even your friendly broker wouldn’t have the nerve to peddle a 100-year bond, if he had any available, as ‘safe.’) Because of the additional risk, the natural reaction of investors is to expect an equity return that is comfortably above the bond return – and 12 percent on equity versus, say 10 percent on bonds issued by the same corporate universe does not seem to qualify as comfortable. As the spread narrows, equity investors start looking for the exits.”

As Mark Twain said, “history does not repeat itself, but it does rhyme.” Food for thought. 

 

Superinvestors of Graham-and-Doddsville

SuperInvestors-GDville.png

The following portfolio management related excerpts are extracted from Superinvestors of Graham-and-Doddsville, an article based on a speech Warren Buffett gave at Columbia Business School on May 17, 1984  

Risk, Expected Return. Volatility

“Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, ‘I have here a six-shooter and I have slipped one cartridge into it. Why don’t you just spin it and pull it once? If you survive, I will give you $1 million.’ I would decline – perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice – now that would be a positive correlation between risk and reward!

The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.

One quick example: The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now so the person who would have paid $400 million would not have been crazy.

Now if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people who think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million and $80 million.”

Risk and reward is not always positively correlated, as traditional financial theory seems to suggest. (For further elaboration on this relationship, be sure to read Chapter 5 of Howard Marks’ book.)

On volatility, although Buffett doesn’t use historical volatility (historical beta) as a measure of risk when determining which securities to purchase, he never explicitly says that investors should ignore future volatility.

Perhaps this is the distinction – observed historical volatility vs. anticipation of future volatility – that reconciles value investing and volatility (price movement) considerations.

Historical volatility should not play a central role in investment decisions (because historical volatility is a bad predictor of future outcome). However, investors (even those from Graham-&-Doddsville) should pay attention to and anticipate future volatility because it impacts the portfolio return stream, as well as other cash, opportunity cost, and firm management considerations.

 

Expected Return, AUM

“When I wound up Buffett Partnership I asked Bill [Ruane] if he would set up a fund to handle all of our partners so he set up the Sequoia Fund…Bill was the only person I recommended to my partners, and I said at the time that if he achieved a four point per annum advantage over the Standard & Poor’s, that would be solid performance. Bill has achieved well over that, working with progressively larger sums of money. That makes things much more difficult. Size is the anchor of performance. There is no question about it.”

During the Partnership days (starting around 1957), Buffett’s goal was to beat the Dow by 10% annually over a long period of time. By 1970, based on the quote above, Buffett thought a 4% annual outperformance over the S&P would be “solid.”

The decline in expected return is either an indication that (1) Buffett believed he could achieve higher returns than Bill Ruane, or (2) Buffett’s portfolio expected return changes with the market environment – with the latter as the more probable explanation.

This idea of shifting expected return is directly applicable to the “equities = annual 8% return” mentality that’s still prevalent among investors today, and fueling all sorts of problems. Ahem, pensions. Future investment returns are a function of market environments and available purchase price, not previously determined or historical return rates – this is true for all investors, including Warren the Great.

Interestingly, Buffett’s expected return figure seems to have declined even further in recent days. At the 2012 Berkshire meeting, to roughly paraphrase Buffett (based on notes taken by Ben Claremon, the Innoculated Investor):

“Todd [Combs] and Ted [Weschler] get a few million dollars in salary and then get 10% of how much they beat the S&P by. This is measured on a rolling, 3 year basis.”

The margin of outperformance above the S&P or Dow has now altogether disappeared. Today, the goal is simply to beat the index.

 

On AUM, Buffett knew/believed from the very beginning (we see evidence of this circa 1963 in the Partnership letters) that increasing assets under management can lead to declining performance. We see this again above in this statement that “size is the anchor of performance.”

So, why then did Berkshire get so big? Or was this AUM-Performance rule only true “on average,” and talented investors were exempt?

Lessons from Buffett's Tax Return

Buffett-11.jpg

The investment management industry has a nasty habit of ignoring the effect of taxes upon returns – mainly because the biggest and most important clients don’t care about pre- vs. after-tax returns (pensions, endowments, foundations, etc.) PM Jar does not agree with this common practice. As a result, our Readers will continue to find posts related to effective and creative tax minimization strategies in a portfolio management context.

 

On the topic of taxes and leverage/margin in a portfolio context, my thoughts brought me back to an old WSJ article on Buffett’s tax return.

There’s lot of speculation in the article, but one particular section stood out:

“Another large element of the gap could be attributable to investment interest expense, which is deductible to the extent that Buffett had investment income—and he did. According to a person familiar with the matter, in the past he has taken out bank loans rather than liquidate shares from his Berkshire Hathaway holdings, which would be a taxable event. Obviously he qualifies for excellent interest rates. Interest expense could also flow through from investment partnerships such as hedge funds.”

Given today’s low interest rate environment (and since interest is tax deductible), could this be a lesson to all of us? Obviously Buffett is older and can use leverage/margin to defer sale of securities until his death. For the average investor, perhaps we should consider using margin or leverage (selectively and prudently) to manage around tax sensitive date thresholds (for example, short-term vs. long-term capital gain).