Wit, Wisdom, Warren (Issue #5): Conservative Investing

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Last time, I reviewed lessons from Warren Buffett’s 1960 letter to partners of Buffett Partnership.

Today, I review the letter for 1961. Buffett wrote two letters during 1961 – once in July 1961 and then the annual letter in Jan. 1962. The first letter carried Buffett’s core rules for the partnerships. It was the annual letter where Buffett talked about his philosophy.

So I’m reviewing just the annual letter (written in Jan. 1962). From this time onwards, I’m also making a change in the way I analyse Buffett’s philosophy.

Given that I am reviewing the letters in a chronological order, I might write about a certain philosophy that Buffett followed in a particular year, which changed in subsequent years.

So, apart from analysing a particular year’s letter, I will try to cull out one specific theme from that letter and then see how that theme evolved for Buffett in the future.

Anyways, let’s start with the analysis of the 1961 letter.

Beating the benchmark
The US Dow Jones Industrial Average (DJIA), after a weak year in 1960, rose by 22% in 1961. Against this, Buffett’s partnerships averaged a return of 46%, thus again outperforming the benchmark.

1961 marked five years of completion of Buffett’s partnerships, and here was his performance so far…

Buffett reiterated his belief in establishing performance yardsticks (the benchmark he wants to beat, which is the DJIA) prior to making his investments, because as he said, “…retrospectively, almost anything can be made to look good in relation to something or other.”

Buffett gave his reasons for choosing DJIA as the benchmark index, which I’m not covering in this review. But you must read it to understand why most mutual fund managers in India have failed to beat the BSE-Sensex.

Buffett on Conservatism
In a world where corporate managers make a mockery of their authority and take for granted their responsibility towards stakeholders, Warren Buffett stands miles apart.

Not only has Buffett achieved a long-term return like no other investor – small or big – has ever achieved, he has done this by following a very conservative approach to investing.

Yes, that’s the word – “conservative”, which is the big idea for today in my review of Buffett’s letters.

In his 1960 letter, while talking about his outperformance of the broader US stock market, Buffett wrote…

Although four years is entirely too short a period from which to make deductions, what evidence there is points toward confirming the proposition that our results should be relatively better in moderately declining or static markets.

To the extent that this is true, it indicates that our portfolio may be more conservatively, although decidedly less conventionally, invested than if we owned “blue-chip” securities. During a strongly rising market for the latter, we might have real difficulty in matching their performance.

Buffett described “conventional investing” as buying blue-chip stocks – ones that are generally traded at rich valuations as compared to non-blue-chip, and despite this fact, are considered as safe havens.

For Buffett, safety of an investment has always negatively correlated with the valuation an investor pays for stocks. So a higher valuation as compared to intrinsic value means lower safety (“What if things go wrong?”) and a lower valuation equates with greater safety.

Thus, Buffett was happy investing in a “conservative” manner, i.e., focusing his sights on non-blue-chip stocks that traded at reasonable to cheap valuations – ones that had large margin of safety attached to them (like Sanborn Map that we discussed in the previous review).

This was classic Benjamin Graham, as Buffett was then 100% Graham (only later did he call himself 85% Graham and 15% Philip Fisher).

What exactly is “conservative” investing?
Here is what Buffett wrote on conservatism in the 1961 letter, and in a few more subsequent letters…

Many people some years back thought they were behaving in the most conservative manner by purchasing medium or long-term municipal or government bonds. This policy has produced substantial market depreciation in many cases, and most certainly has failed to maintain or increase real buying power.

Conscious, perhaps overly conscious, of inflation, many people now feel that they are behaving in a conservative manner by buying blue chip securities almost regardless of price-earnings ratios, dividend yields, etc. Without the benefit of hindsight as ill the bond example, I feel this course of action is fraught with danger.

There is nothing at all conservative, in my opinion, about speculating as to just how high a multiplier a greedy and capricious public will put on earnings.

You will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you. In many quarters the simultaneous occurrence of the two above factors is enough to make a course of action meet the test of conservatism.

You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.

Well, as Buffett mentioned and what is true of how investors and experts think today, conservative investing is generally thought of as putting money away in the biggest, most stable companies which in turn “guarantee” safety of principal.

The thought process goes like this – “If my investment in this safe, blue-chip company appreciates in value, it would be great. But even if it doesn’t, at least being conservative will help me sleep better at night.”

Dear reader, this may indeed be true, but unless you’re ready to ignore inflation, you may be having it backwards when it comes to conservative investing.

While it’s indeed true that companies from the so called defensive sectors like FMCG and utilities are defined as conservative, simply buying the large, well-known companies does not fulfill the goal of a successful conservative investment approach.

We have enough cases like Satyam, Suzlon, Reliance Power, DLF, Unitech, and many other companies that were supposedly “large and well-known” in the yesteryears, and that have created massive destruction of capital for investors.

As Buffett would want you to understand, there is one simple way to look at a conservative investment.

Conservative investment = Preservation of capital
A conservative investment is one that has the greatest probability of preserving your purchasing power and with the least amount of risk.

This probability can in turn arise from the process that you follow to identify such opportunities that will preserve your purchasing power in the future.

So, as an example, if you buy Infosys at RS 2,500 while fully understanding the risks involved and knowing that there’s a high probability that the stock will help you preserve capital, that would be conservative investing.

But if you buy Infosys at Rs 2,500 without knowing the risks involved and just because you are anchored to its recent price rise, or because everyone else thinks the stock is going to rise in the future, that won’t be conservative investing. In fact, that would be speculation.

So, where most investors fail in attempting to invest “conservatively” is blindly assuming that by purchasing any security that qualifies as a conservative investment, they are in fact, conservative investors.

In other words, such investors are thinking conservatively, but not acting conservatively.

If you indulge in such things, dear tribesman, it could prove to be a costly affair.

To reiterate Buffett, as an investor…

…you will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you. In many quarters the simultaneous occurrence of the two above factors is enough to make a course of action meet the test of conservatism.

You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.

That’s the key point here – True conservatism is only possible through knowledge and reason. Everything else is conventional, and thus a fast way to permanently destroy capital.

How to find “conservative” investments?
Buffett resisted buying large and popular companies because he thought this category was valued irrationally by investors. But then, he was not in favour of buying small, unproven companies as well. As he wrote in his 2010 letter…

At Berkshire, we make no attempt to pick the few winners that will emerge from an ocean of unproven enterprises. We’re not smart enough to do that, and we know it.

Instead, we try to apply Aesop’s 2,600-year-old equation to opportunities in which we have reasonable confidence as to how many birds are in the bush and when they will emerge (a formulation that my grandsons would probably update to “A girl in a convertible is worth five in the phonebook.”).

Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners.

Even so, we make many mistakes: I’m the fellow, remember, who thought he understood the future economics of trading stamps, textiles, shoes and second-tier department stores.

This reiterates Buffett’s key definition of conservatism over these years – conservatism depends on how you choose and not what you choose.

In other words, investing conservatively is not about simply identifying large well-known businesses, but going through a process that identifies why a particular company qualifies as a conservative investment.

Taking some cues from Buffett’s letters over the years, here are some characteristics of a conservative investment:

1. Ability to weather market storms better than most – Low cost of production, pricing power, high and stable return on invested in capital, zero or negligible debt.

2. Managed by excellent people – But only a business that fulfils the first criteria above. As Buffett says so often, “When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” So the business quality is far more important than management quality. Of course the management has to be a great allocator of capital and ethical.

3. Possessing sustainable moat – Ability to grow profits and profitability despite competition.

4. Available at a good discount to intrinsic value – This is a tough characteristic to find, but herein lies the real test of patience for a conservative investor.

Here is what Buffett wrote in 1965…

Truly conservative actions arise from intelligent hypotheses, correct facts and sound reasoning. These qualities may lead to conventional acts, but there have been many times when they have led to unorthodoxy. In some corner of the world they are probably still holding regular meetings of the Flat Earth Society.

We derive no comfort because important people, vocal people, or great numbers of people agree with us. Nor do we derive comfort if they don’t. A public opinion poll is no substitute for thought. When we really sit back with a smile on our face is when we run into a situation we can understand, where the facts are ascertainable and clear, and the course of action obvious. In that case – whether other conventional or unconventional – whether others agree or disagree – we feel – we are progressing in a conservative manner.

The above may seem highly subjective. It is. You should prefer an objective approach to the question. I do. My suggestion as to one rational way to evaluate the conservativeness of past policies is to study performance in declining markets.

Lessons for business managers
Buffett’s thoughts on conservatism were not only meant for investors but also for business managers. Buffett is, after all, an astute businessman first and an investor later.

This is what he wrote in 1983…

We rarely use much debt and, when we do, we attempt to structure it on a long‐term fixed rate basis. We will reject interesting opportunities rather than over‐leverage our balance sheet.

This conservatism has penalized our results but it is the only behavior that leaves us comfortable, considering our fiduciary obligations to policyholders, depositors, lenders and the many equity holders who have committed unusually large portions of their net worth to our care.

Then, here is what Buffett wrote in 2006, at the height of the madness in the global business scenario. Remember this was the time when most businesses globally and in India were aggressively pursuing supernormal growth at the expense of their balance sheet safety.

We are not interested in incurring any significant debt at Berkshire for acquisitions or operating purposes. Conventional business wisdom, of course, would argue that we are being too conservative and that there are added profits that could be safely earned if we injected moderate leverage into our balance sheet.

Maybe so. But many of Berkshire’s hundreds of thousands of investors have a large portion of their net worth in our stock (among them, it should be emphasized, a large number of our board and key managers) and a disaster for the company would be a disaster for them. Moreover, there are people who have been permanently injured to whom we owe insurance payments that stretch out for fifty years or more. To these and other constituencies we have promised total security, whatever comes: financial panics, stock-exchange closures (an extended one occurred in 1914) or even domestic nuclear, chemical or biological attacks.

We are quite willing to accept huge risks. Indeed, more than any other insurer, we write high-limit policies that are tied to single catastrophic events. We also own a large investment portfolio whose market value could fall dramatically and quickly under certain conditions (as happened on October 19, 1987).

Whatever occurs, though, Berkshire will have the net worth, the earnings streams and the liquidity to handle the problem with ease. Any other approach is dangerous. Over the years, a number of very smart people have learned the hard way that a long string of impressive numbers multiplied by a single zero always equals zero. That is not an equation whose effects I would like to experience personally, and I would like even less to be responsible for imposing its penalties upon others.

I think this serves as a great reading for any businessman starting out on what not to do, or for any businessman who has failed in the past and wants to restart on a clean slate.

I also wish most Indian business houses take lessons from what Buffett has to say on how to conduct business conservatively. They have a moral and social responsibility to do so!

Lessons for individuals
In 2011, Buffett carried a segment in his letter to shareholders. He titled it “Life and Debt”.

Read this as a lesson on how you must manage your personal finances, and what you must also teach your children for their safe financial future.

The fundamental principle of auto racing is that to finish first, you must first finish. That dictum is equally applicable to business and guides our every action at Berkshire.

Unquestionably, some people have become very rich through the use of borrowed money. However, that’s also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade – and some relearned in 2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.

At the end of this segment, Buffett also shares a letter written by his grandfather to his (Buffett’s) uncle Fred. This letter talks about the importance of maintaining an emergency fund, and as Buffett has confided, has been partially responsible for his aversion to financial adventurism, or in other words, his favouring of conservatism as a businessman and an investor.

It reads as follows…

Dear Fred & Catherine,

Over a period of a good many years I have known a great many people who at some time or another have suffered in various ways simply because they did not have ready cash. I have known people who have had to sacrifice some of their holdings in order to have money that was necessary to have at that time.

For a good many years your grandfather kept a certain amount of money where he could put his hands on it in very short notice.

For a number of years I have made it a point to keep a reserve, should some occasion come where I would need money quickly, without disturbing the money that I have in my business. There have been a couple of occasions when I found it very convenient to go to this fund.

Thus, I feel that everyone should have a reserve. I hope it never happens to you, but the chances are that some day you will need money, and need it badly, and with this thought in view, I started a fund by placing $200 in an envelope, with your name on it, when you were married. Each year I added something to it, until there is now $1000 in the fund.

Ten years have elapsed since you were married, and this fund is now completed.

It is my wish that you place this envelope in your safety deposit box, and keep it for the purpose that it was created for. Should the time come when you need part, I would suggest you use that you use as little as possible, and replace it as soon as possible.

You might feel that this should be invested and bring you an income. Forget it – the mental satisfaction of having $1000 laid away where you can put your hands on it, is worth more than what interest it might bring, especially if you have the investment in something that you could not realize on quickly.

If in after years you feel this has been a good idea, you might repeat it with your own children.

For your information, I might mention that there has never been a Buffett who ever left a very large estate, but there has never been one that did not leave something. They never spent all they made, but always saved part of what they made, and it has all worked out pretty well.

This letter is being written at the expiration of ten years after you were married.

Ernest Buffett

“Dad”

Conservatism & decision making in investing
The legendary management guru, Peter Drucker, wrote in “The Effective Executive” that, before making a decision, one has to start out with what is right rather than what is acceptable, precisely because one always has to make compromise at the end.

So people, who are trying to invest conventionally (or like what others are doing) might make a random decision arguing, “Half a loaf is better than no bread.”

But as the story of the Judgment of Solomon so clearly suggests, “Half a baby is worse than no baby at all.”

This is so true in investing. Taking the easy way out – investing like others are doing, and in the same kind of stocks – will seem like a “half a loaf” to you. It may well turn out to be “half a baby”!

Anyways, in the 1961 letter, Buffett wrote about some other ideas, like about his investment in Dempster Mill Mfg. Co., which I will cover in the subsequent posts.

As of now, I would like to know whether you practice conservatism in your investing or not. If yes, what are the rules of conservatism that you follow?

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