Gurus for the Win

Color Commentary

 

1. 50% “Requirement”

We ran out of time in our last AMA video call before I could answer all the questions, and then stupid Zoom lost the record of the Q&A. I’m still mad at Zoom about it, because they were insightful questions and I really wanted to get at answering them. It’s such a pleasure to be part of this community of intelligent investors. After that, few of you sent in your questions to be answered here. Doing so actually turned out to be a blessing in disguise, because I’ve had so much fun researching the answers to these excellent questions, and more importantly, my answers are much better researched and more complete than they would have been off-the-cuff on the call. Thank you! Please continue to send in questions.

Question from Nicole: Do you ever reduce your margin of safety (e.g. buy at a 30% discount to intrinsic value instead of a 50% discount) because you believe that your wonderful company (which meets all of the other Ms) is never going to go on a 50% sale?

Hi Nicole! I don’t think it’s a great idea to reduce the 50%.

That said, it’s up to you as an investor to choose what level of risk you want to take. Charlie Munger calls a margin of safety price “a price that makes sense.” He’s never said one word that I’ve found about that price being exactly 50% or 45% or 75% lower, or any number in particular. He just says to choose a price that makes sense, with a margin of safety.

Warren Buffett has said, “The three most important words in investing are margin of safety.” On top of that, the saying is often attributed to him that we want to buy a dollar bill for fifty cents to create that large margin of safety, which is where this idea of the standard 50% discount probably arises.

He may have said that, using 50% or 50 cents, at some point, I don’t know. It’s often attributed to his famous “Superinvestors of Graham-and-Doddsville” speech to Columbia Business School in 1984. So, I looked it up and read it again. Turns out, he didn’t talk about buying a dollar for 50 cents. Instead, he said, quoting investor Walter Schloss: “if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me.” (page 9 of the article)

Buy a dollar for 40 cents, not 50 cents. 40% off – even less than 50% off. Interesting, right?

He went on to add: “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.” (page 14 of the article)

There’s your answer, from both Warren and Charlie. We’re all free to buy at a price that makes sense, and if the price that makes sense is 60% of its value and I’m willing to take the additional risk that creates, then that’s my choice. Obviously, buying at 40% of its value is safer.

I’ll also add that another metric I think about when pricing is whether it is enough of a reduction to be relatively safe if my pricing/valuation calculations are off. Which, let’s face it, they probably somewhat are, because we are not crazy mathematicians running equations all day – at least, I am not. So we assume our calculations are somewhat off, and we assume we made some mistakes, and the 50% amount is enough to compensate for those rounding errors and to provide the discount to true value. Or, to turn again to Buffett’s Superinvestors speech: “You also have to have the knowledge to enable you to make a very general estimate about the value of the underlying businesses. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin.” (page 14 of the article)

Every time I read “The Superinvestors of Graham-and-Doddsville,” I learn something new. This time, what’s stuck with me is the quote just above, admonishing me “you do not cut it close.” Don’t try to buy businesses worth $83 million for $80 million. I get annoyed with the same situation you do, Nicole, in this market, and always want companies that I want to own to be priced low enough to buy. Now I have in my head “do not cut it close.” And maybe I’m even going to aim for 60% discount instead of a 50% discount.

2. B**t Earnings

Question from Lisa: in your book, your dad said to be suspicious/skeptical of companies using EBITDA in their financial statements. Why? They must serve some useful purpose because I see them everywhere! I’ve even heard that Buffett and Charlie use them to calculate fair value.

Hi Lisa! I’m not going to answer for my dad, but from my own experience facilitating buying and selling companies as an attorney, yes, businesspeople use EBITDA like crazy because it usually makes their results look better, and because it lets them compare earnings without those deductions that will vary greatly from year-to-year. It’s not a totally useless metric, but I do find it rather uninteresting as a long-term investor because interest, taxes, depreciation, and amortization are real costs that have to be paid. They’re not imaginary, and EBITDA kind of allows people to treat those costs as if they’re imaginary and will never have to be paid.

I totally understand why you’ve got this question, because EBITDA IS used so often. SO often. So, clearly understanding why and how is key. To understand, I, of course, turned to our dear gurus.

According to these excellent notes of Buffett’s many shareholder meeting comments (I haven’t actually checked the tape, but these transcripts seem pretty legit and linked to by trustworthy sources), Buffett was asked at the 2002 Berkshire Shareholder Meeting his thoughts on EBITDA. His answer:

“It amazes me how widespread the use of EBITDA has become. People try to dress up financial statements with it.

We won’t buy into companies where someone’s talking about EBITDA. If you look at all companies, and split them into companies that use EBITDA as a metric and those that don’t, I suspect you’ll find a lot more fraud in the former group. Look at companies like Wal-Mart, GE and Microsoft — they’ll never use EBITDA in their annual report.

People who use EBITDA are either trying to con you or they’re conning themselves. Telecoms, for example, spend every dime that’s coming in. Interest and taxes are real costs.”

And again, the next year, in 2003, when he was asked what adjustments, such as EBITDA, he makes to reported earnings:

“[When goodwill was required to be amortized,] we ignored amortization of goodwill and told our owners to ignore it, even though it was in GAAP [Generally Accepted Accounting Principles]. We felt that it was arbitrary.

We thought crazy pension assumptions caused people to record phantom earnings. So, we’re willing to tell you when we think there’s data that is more useful than GAAP earnings.

Not thinking of depreciation as an expense is crazy. I can think of a few businesses where one could ignore depreciation charges, but not many. Even with our gas pipelines, depreciation is real — you have to maintain them and eventually they become worthless (though this may be 100 years).

It [depreciation] is reverse float — you lay out money before you get cash. Any management that doesn’t regard depreciation as an expense is living in a dream world, but they’re encouraged to do so by bankers. Many times, this comes close to a flim flam game.

People want to send me books with EBITDA and I say fine, as long as you pay cap ex. There are very few businesses that can spend a lot less than depreciation and maintain the health of the business.

This is nonsense. It couldn’t be worse. But a whole generation of investors have been taught this. It’s not a non-cash expense — it’s a cash expense but you spend it first. It’s a delayed recording of a cash expense.

We at Berkshire are going to spend more this year on cap ex than we depreciate.”

Charlie Munger then added: “I think that, every time you saw the word EBITDA [earnings], you should substitute the word “bullshit” earnings.”

Charlie has repeated that line over and over, most recently at his Daily Journal shareholder meeting this year, so clearly his views have not changed in the intervening 17 years.

I noted that Buffett cited three companies in 2002 that don’t use EBITDA in their annual report: Wal-Mart, General Electric, and Microsoft. That was a long time ago, and management has changed at all those companies, so I wondered if they still don’t use EBITDA in their annual report? My guess was there’s no way, it’s so common that they probably throw it in there by now.

Nope. Totally wrong. I looked up each current annual report and did a search, and Microsoft and Wal-Mart do not mention EBITDA. General Electric does, in particular reference to its Net Debt, which is large, and they’re using EBITA to try to make their debt sound smaller in relation to earnings than it actually is.

FASCINATING. I’m kind of freaking out over this metric of whether or not an annual report mentions EBITDA. Microsoft and Wal-Mart have soared in the last fifteen years. General Electric has lost almost all of its value. Now, obviously, that could be a total coincidence. Maybe it is. But it is instructive coincidence, is it not? It is coincidence that might still lead to better companies than not.

What a cool yes/no metric to add to my checklist! And so easy to find an answer.

3. Only Three Stocks?

I looked into two guru investors and their 13F filings: Li Lu and Allan Mecham.

Li Lu manages some of Charlie Munger’s money, and as such, has become rather an investing guru to the investing gurus. He has given two talks to Columbia’s value investing class. Here is his 2006 talk (video), and here is his 2010 talk (transcript). They’re worth watching/reading.

One thing I took away from his 2010 was to look back at the failures of a given industry, to help yourself understand how a company can go down.

Question from audience: I read that when you look at an industry, you look at the most miserable failures of that industry to see whether you will invest in it. Can you talk a bit about that?

Li Lu: It goes back to understanding the business. Once you have that understanding you can extend it to understanding an industry. A certain industry might have characteristics that make it different than others. In certain industries you might have better prospects than others. Find the best of the players in the industry and the worst players. And see how they perform over time. And if the worst players perform reasonably well relative to the great players — that tells you something about the characteristics about the industry. That is not always the case but it is often the case. Certain industries are better than others. So if you can understand a business inside out you can then eventually extend that to understanding an industry. If you can get that insight, it is enormously beneficial. If you can then concentrate that on a business with superior economics in an industry with superior economics with good management and you get them at the right price — the chances are that you can stay for a very long time.

Li Lu runs Himalaya Capital Management in Seattle, and we can find out what he owns. I looked it up on the SEC’s Edgar search. Here are his two most recent 13-F filings: Quarter ending 3-31-30, and Quarter ending 12-31-19.

You can see that the EDGAR formatting leaves quite a lot to be desired, and it’s really hard to track buying and selling positions without opening a million tabs of all the past 13-Fs and going back and forth between them to check the number of shares bought/sold. Frustrating. There’s a big hole here for an aggregator to provide better info. WhaleWisdom isn’t a bad free source – here is its Himalaya page – and Finbox is another one with decent information – here is its Himalaya page. I know a number of investors who pay for GuruFocus for its 13-F layout of the data, and I haven’t made that leap to paying for information yet, but who knows, maybe I’ll get really frustrated with the free resources and will pay at some point.

At the end of last year, Himalaya owned only Micron Technology, and as of end of March, Himalaya had added Bank of America and a small amount of Alibaba. Short list! It’s a great reminder for us that 13-F filings really do not show the whole picture. They only require disclosure of US securities if the fund holds more than $100 million of them. Himalaya is known for investing in China and other countries, and those holdings are not disclosed in the SEC’s 13-F process.

But who cares!? That’s 3 potential leads of companies that would be extremely interesting to review, and because Himalaya owns so few, it’s a pretty strong sign that they are very confident in these investing choices.

Allan Mecham runs Arlington Value Capital in Utah, and he’s a great example of a fund manager who adheres to very long-term bets with Buffett-style patience. Here’s some background on him, and the “400% Man” article that made him famous (WSJ paywall). He’s become known not only for his returns, but also for his excellent writing about value investing, and I found this lovely compilation of his letters to investors which is a quite a lot of reading, but massively educational. Unlike most investors, including me, he is willing to comment on some of his portfolio holdings. Notice what he wants his investors to know. For one great example, check out page 38 and 39 of the PDF of his letters for his commentary on why Outerwall was a mistake, and why NOW and MSC Direct were not mistakes despite their stock prices going down. It’s especially interesting with the benefit of hindsight and market data, because now the price of NOW Inc. is about half of what it was in 2016 when Mecham wrote that letter, and he was out of that investment by 2017 (see his comments on page 44 of the PDF of his letters). At each stage he shared his opinion and its changes with his investors, and that is the kind of intellectual honesty I want to see in a money manager.

Mecham announced recently that he’s closing his fund, which was a shock to the investing world because he was doing well and growing. I can’t find a reliable link to that news, but I have read the letter he sent to investors announcing his wind-up and it’s definitely happening. I think he wants to live a less stressful life, and has enough money to do so. It’s intriguing, therefore, to look at his last 13-F as he’s winding up. Here’s Arlington’s Edgar page and its most recent 13-F filing. Mecham owns a LOT more companies than Li Lu.

Total list, just from these two investors:

Himalaya:
Alibaba
Bank of America
Micron

Arlington (I’ve left out the tiny holdings):
Alliance Data Systems
AutoNation
Berkshire Hathaway
Cimpress
Covetrus
Liberty
Interactive Brokers
Jeffries
Monro Muffler & Brake
Spectrum Brands
Wayfair

LET’S GET PRACTICAL

This is an absolutely incredible resource of Buffett’s thoughts, organized by topic rather than by year. Incredibly helpful. If I spend my weekend reading this, it won’t be wasted.

CNBC’s trove of Buffett resources, videos, transcripts

Notes from a more recent speech by Li Lu

Li Lu’s Columbia speeches: 2006 and 2010

Allan Mecham’s compendium of letters to his investors

Ownership Disclosure: Danielle Town owns shares in Berkshire Hathaway (BRK) .

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