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>>> Buffett's Surprising New Moves Fit His Core Principle: Have An Edge


Sep. 25, 2020

Seeking Alpha

by Jim Sloan


https://seekingalpha.com/article/4376207-buffetts-surprising-new-moves-fit-core-principle-edge


Two recent Buffett actions may seem out of character: a $6.5 billion investment in stodgy Japanese trading companies and a $500 million investment in hot IPO Snowflake; what's up?

Buffett formed many lifetime principles as a 16-year-old horse handicapper, including the importance of information, sizing bets, and having an edge over the opposition.

This applied in his "cigar butt" years, his blue chip ROIC years, his use of insurance float, his utility/railroad acquisitions, and his deals; in all cases he had an edge.

Despite striking out in new directions his recent actions each involved an edge which improved upon the ordinary odds and applied such racetrack/casino principles as properly sizing bets.

Buffett's greatest edge may be in knowledge stemming from Berkshire itself, both for buybacks and for buying assets such as Dominion's pipelines for which Berkshire Hathaway Energy provided an information advantage.

"Plus ca change, plus c'est la meme chose (the more things change the more they stay the same)" - epigram by Jean-Baptiste Alphonse Karr, 1824

What's up with Buffett? Is he bent on taking Berkshire Hathaway (BRK.A)(BRK.B) down new and radical paths? The short answer is yes. The short answer is also no.

Two recent actions may have struck Buffett watchers as out of character. First he reveals that over the past year he bought a $6.5 billion stake in five relatively stodgy Japanese trading conglomerates known in Japan as sogo shosha. Then within a matter of weeks he announces that Berkshire has taken a small but significant stake in the year's hottest IPO, Snowflake (SNOW), using two different approaches just a few days before the IPO. Buffett had previously made it clear that IPOs were not for him or Berkshire. What's up with all that? Has he taken leave of his... basic principles?

In this article I'll take a hack at the long answer, which starts with a few basic principles he learned as a teenager. The world changes. The markets change. But remember the French proverb cited above. Whether it's algorithmic trading, new forms for companies going public, or merely great generational changes in what's working in the markets, there's a need for both a core of basic principles and a carefully measured flexibility of mind.

But where can you discover the kind of principles that are powerful and general enough to work in many different markets and circumstances? As it turns out, Buffett's first encounter with the most fundamental principles for investing came to him at an unexpected place and a surprising age. He wasn't just the typical nerdy kid who bought a stock or too in a custodial account - he did that too, of course, and made a total of five bucks on three shares of Cities Service Preferred. But hey, lots of kids do that kind of thing, which is fun and makes you feel prematurely grown up. I did a bit of it myself, but I clearly did not grow up to be Buffett. Having an interest in stocks as a kid is probably best described as necessary but not sufficient. Buffett went to a much stranger place to learn the right questions to ask about stocks.

What you really need is an opportunity to discover a few basic principles that will stand the test of time. They should be as relevant at the end of your career as when you are just starting out and make sense whether you are young or old. Buffett had a bit of luck with ideas he bumped into in the course of an unusual teenage experience.

Buffett Learned Core Principles At The Racetrack

The most powerful investment instruction for the sixteen-year-old Buffett took place at the race track. Still back in Nebraska he and a friend started by "stooping" the floor for "place" and "show" tickets discarded by naive bettors disappointed that they didn't have the winner. In their naivete they didn't realize that their tickets paid out modestly for 2d and 3d place as well. There's a value investing metaphor somewhere in this which closely resembles Buffett's original model of picking up "cigar butt" stocks which were discarded but had one more puff in them.

What Buffett did next was more interesting. He and a friend put out a tip sheet called Stable-Boy Selections. To do this he began to study handicapping, and in the process learned such things as the fact that you could handicap by speed or by the class the horse had competed successfully against. They sold their tip sheet for a quarter until the race track shut them down. A year later with a teacher who was also interested in horses, he returned to the racetrack and instead of "stooping" or selling a tip sheet, he bought the best tip sheet, studied, and formulated a plan.

I'd get the Daily Racing Form ahead of time (he told biographer Alice Schroeder) and figure out the probability of each horse winning the race. Then I would compare those percentages to the odds. But I wouldn't look at the odds first, to avoid prejudicing myself. Sometimes you would find a horse where the odds were way, way off from the actual probability. You figure the horse has a ten percent chance of winning but it's going off at 15 to 1 (implying only a 6.7% chance so that the payout probability exceeded the odds by about 50%)."

What Buffett had stumbled upon was the concept of having an edge, in this hypothetical case a 50% edge on what was admittedly a long shot, although betting on a large number of such long shots would likely be highly profitable. The basis of success was that you were betting against people who based their choices on the jockey's colors or the names of the horses. Implicit in this process was the most important principle behind any kind of betting, using edge/odds as a guideline for sizing bets or deciding whether to bet at all.

This simple criterion is actually a version of one of the most sophisticated approaches to any game involving information and played under uncertainty. This principle involving the use of edge/odds for proper sizing of bets (including the decision not to bet) is called the Kelly Criterion after mathematician and information theorist John Kelly. Kelly worked at Bell Labs with Claude Shannon, also a mathematician and the inventor of information theory, who ultimately became a famously successful investor using legal inside information. A system counting the fives to size bets in blackjack was put together by Ed Thorpe, who also knew Shannon at MIT. Thorpe used this approach to beat blackjack dealers, a system he wrote about in Beat the Dealer. Thorpe later ran a successful hedge fund which prefigured today's algorithmic trading.*

Buffett is neither a high-order mathematician nor an information theorist, but he is very quick with basic math and its implications. He didn't miss the main thing. He was a decade ahead of the mathematicians and information theorists thanks to his experiences at the race track. Here are the major principles Buffett took away from his race track experiences, good and bad:

Information is everything. The way to win is to have more information than the other guy.

Opportunity arises whenever other bettors or market participants are naive, lazy, badly informed, under pressure to deal, or simply not very smart.

Always look for an edge.

Size your bets appropriately based on edge/odds.

You don't have to bet every race.

Looking closely, you can see these principles ripple through every major stage of Buffett's career.

The Partnership Years

These simple principles applied with the analytical methods he learned from Ben Graham enabled Buffett's original hedge fund (The Partnership) to return 29.5% before fees (24.5% after) versus 7.4% for the Dow with no down years between 1956 and 1969. The market was simpler in those days, and many players were as badly informed as a bettor playing the jockey's colors or the horse's name. Buffett won by doing his homework and having the information advantage that came with command of detail. He also employed the concept of having a "margin of safety," which amounts to undertaking only bets which have a high probability of success.

In 1969 Buffett closed the partnership on the grounds he was finding it difficult to discover mis-priced stocks. In reality, he had perfectly timed the end of a long bull market and chose to follow the key principle that you don't have to bet every race.

Float, Moat, And ROIC

The trouble with finding "cigar butt" stocks was that as soon as they closed the gap to fair value you had to find another one. There had to be a better way, and Charlie Munger provided one. The trick was to buy stocks with high return on invested capital and a good place to reinvest it. The next thirty years at Berkshire Hathaway were driven by two investment themes:

Property and casualty insurance companies which provided an underwriting profit if managed well and at the same time created a "float" of customer payments which was essentially free if your underwriting was good and became a free source of cash to invest.

Quality companies with outstanding products and brands which served as a "moat" to hold off competitors and also high return on invested capital which they were able to compound internally. They were wonderful if you could purchase the company outright, as with See's Candy, but they were also pretty darn good if you simply bought gobs of the stocks, as Buffett did with Coca-Cola (KO) and American Express (AXP). He holds them still, decades later, and happily receives a rising stream of dividends which annually exceed his purchase price.

Warren and Charlie more or less invented the concepts of "float" and "moat" as investment edges, and while they were not the only people to think about ROIC, they were early in understanding that it was the underlying force behind growth. Put together, the three concepts - moat, float, and ROIC - worked brilliantly and were the main drivers of Berkshire's extraordinary growth in value until Berkshire began to feel the pressure of holding too much cash.

Assured Profitable Reinvestment

In 1999 Buffett's struck out in another new direction by buying a control position in Mid-American Energy. Although utilities had slow user growth and their rates were regulated, they enjoyed an advantage which came with regulation: an assurance of a reasonable return on capital required to maintain their service. Given the low cost of cash from insurance float, companies in a regulated industry were a bond-like sure thing. Berkshire Hathaway Energy - now a large unit of Berkshire overseen by Buffett's likely successor Greg Abel - embarked on two decades of bolt-on acquisitions and purchased any infrastructure assets that became available.

Railroads had similar advantages, and Buffett was able to acquire BNSF by a handshake golf-course deal with CEO Matt Rose. Industrial companies in general shared some but not all of these advantages, and Buffett was the buyer of choice for privately owned Israeli metalworking company Iscar and a cluster of industrial assets which no longer fit the portfolio of the Pritzker family. His edge in these purchases was having capital on hand, and in the case of Iscar providing the individual owner a chance to cash out by selling his lifework to a company which would continue it as he would have.

Deals When The Other Side Is Highly Motivated

Nothing shows the use of an edge better than the deals cut with Dow Chemical (DOW), Harley Davidson (HOG), Goldman Sachs (GS), and GE (GE), all of which were stuck in a tough situation because of the 2008-9 crisis. There's no better edge than the one you have when the other side is desperate. Receiving preferred shares at high interest dates, with early payback penalties and kickers in the form of warrants, made these deals a rare combination of low risk and high return.

The home run of these deals was his $5 billion purchase of preferred shares from Bank of America (BAC) in 2011. The market feared that BAC was about to fail, and Buffett called to make them an offer they couldn't refuse (which had popped into his head while taking a bath). With the preferred shares he received 6% interest along with warrants which were then out of the money but subsequently enabled him to purchase BAC at a price which which has subsequently tripled.

No Edge Works All The Time

It should be noted that the prospects for Buffett's similar deal with Occidental Petroleum (OXY) have been greatly damaged by the COVID lockdown, along with his four airline investments. Several wholly owned Berkshire subsidiaries have also seen a reduction in their immediate prospects, including the relatively large 2015 acquisition of airline-related Precision Castparts. Even with an edge, be it deal structure or general market acumen, not all bets work out.

The long period of low rates has made marginal investments more attractive, but the several problem investments of recent years should be taken in context. Buffett has more often been criticized for not taking action than for actions he actually took. The bets that didn't work out were generally small on Berkshire's scale assuming that Precision Castparts is likely to bounce back over time. What comes in for little positive notice is the virtue of Buffett's relative inaction. A product of overall market conditions that existed before COVID, this clearly represents the principle of not betting at all when the odds are insufficiently favorable.

Using An Edge In Buying Japanese Trading Companies

Many people did not notice at the time - and I did not make it an aspect of my analysis - that Buffett's purchase of equal amounts in five Japanese trading companies had a particularly favorable twist. My own initial thought was that the companies were vital and produced stable dividends, albeit a dividend stream somewhat lumpier than that of most large American companies. These sogo shosha thus fit the longtime Buffett model of stocks as "equity bonds", producing a bond-like return in the form of dividends accompanied by a reasonable prospect of modest price appreciation.

Dividends received within Berkshire are very valuable because more favorably treated under current corporate tax laws than capital gains. Though anything can happen when it comes to taxes, a corporate tax increase is much less likely than a tax increase for affluent individuals because of the argument that American business must be competitive with foreign businesses. The equity bond aspect was reflected in Buffett's buying these company's within National Indemnity, where their regular dividend payment could offset future expected payouts. Every operational aspect, therefore, was well thought out.

There was, however, one factor which has not been prominent in discussions, including my own initial analysis. The $6.5 billion outlay for shares in the five companies - Itochu (OTCPK:ITOCF), Marubeni (OTCPK:MARUF), Mitsubishi (OTCPK:MSBHF), Mitsui (OTCPK:MITSY), and Sumitomo (OTCPK:SSUMF) - was almost exactly offset by borrowings denominated in yen at the hyper-low interest rates in Japan - ranging from .17% to 1.1% in the case of the yen loans. Thus with average dividend rates of the five companies around 4%, the purchase of the five companies involved a carry trade of sorts, or arbitrage if you prefer. In essence Buffett and National Indemnity were receiving very secure payments roughly 3% above the cost of funds, with changes in exchange rates removed from the picture. Much like insurance float, it was essentially free money with a suitable investment available for putting it to use.

It will be interesting to see whether this major foray into international investing also leads to Buffett operating within an expanded universe of potential investments. It could be that Buffett simply sees in Japan, an obvious low risk way to participate in the growing Pacific Rim, a more favorable situation than in most foreign markets. It is also possible that Buffett may expand the size of his bet on the five sogo shosha, where he can double his investment without regulatory objection. He may also branch out into other areas of the Japanese market.

Using An Edge To Buy In Front Of The Snowflake IPO

The purchase of some $500 million of the Snowflake (SNOW) IPO was perhaps the most surprising move Buffett has ever made. In every respect it appears to violate principles explicitly stated and observed in Buffett's past. It is, first of all, a tech company, and it comes with all the difficulties of analyzing tech, especially very young tech startups. Buffett has spoken of the problems that come with Initial Public Offerings and the extreme unlikelihood of his ever buying into one. It is also extraordinarily expensive by all measures, has no profits, and sells on the basis of an enormous multiples of bookings. Buffett has steered clear of all such companies in the past. Why change his approach now?

There are a few positive aspects particular to Snowflake which Buffett must have considered. For one thing, the business model is very well designed as tech startups go, with a clear sense of the ultimate scale of their data cloud storage-and-accessing market and also a reasonable ability to estimate their likelihood of capturing large market share. Current growth matches up well with the IPO price if it is likely to persist for a considerable period, always a big if. Berkshire is in good company, as Salesforce (CRM) equalled their commitment to the IPO. That's an important imprimatur from a company certainly extremely well informed about the opportunity and risks, as well as the process moving from private equity startup to public company.

In an article I wrote on great contemporary market winners I invoked the implied Adam Smith view that such companies might reasonably be viewed in the beginning not by current metrics but by an informed estimate of the market they will eventually serve and the share of it they will attain. This view appears from the initial mission statement to be exactly the way Jeff Bezos formed Amazon (AMZN).

I can't resist thinking that Todd Combs had some role in this, especially considering that he was the instigator of the thus far successful investment in Brazilian payments company StoneCo (STNE) and Indian payments company PayTm, in which Ant Financial has also invested and which is scheduled to go public in 2022. On the other hand,
the second part of Berkshire's investment, a private deal to buy the shares of early private investors - an amount equal to the IPO commitment - has more the feel of a Buffett action.

The edge here? For one thing, it turns out that arranging to buy in both cases at the IPO price had a huge advantage in retrospect. Almost all day one investors ended up paying well over twice the IPO price. Maybe this price is also way off base, but only time will tell. It's also important to be aware of the sizing of the bets. The combined price paid for Snowflake is less than combined investments in StoneCo and PayTm, and is quite small when compared to Berkshire's available cash. It is also just under 10% of the price paid for the four Japanese trading countries, which are less exciting but far more likely to meet the smaller objective of a steady and rising dividend payout.

If you had to sum it up, Berkshire made one very conservative bet in a foreign market and one much smaller bet in a company with high risk but enormous upside and the advantage of getting in at an early point - the sort of bet that recent years has turned out pretty well for informed investors in tech IPOs, especially if executed with some price advantage.

Buffett's Most Important Edge

I would be remiss not to mention the single area in which Buffett has the greatest edge: Berkshire itself. So far in 2020 Buffett has bought back at least $7 billion in combined Berkshire A and B shares, probably more than he invested in the Japanese companies and Snowflake combined. This should come as no surprise. Berkshire has lagged the market and is relatively cheap by many measures, even after reduced earnings including a large write-down of Precision Castparts.

The important fact not to miss is that Buffett knows the risks and the value of his own company better than anyone else possibly could and also better than he could possibly know any other potential investment. It should get the attention of other investors that he has begun to size the buyback bet as having a higher probability of good return than any other investment he currently sees. One should also remember that Buffett has no personal interest in Berkshire buybacks except what he shares with all continuing shareholders (he is careful to buy back at prices which do not disadvantage either holders who exit or holders who stay).

There's also another information edge that comes with being at the center of Berkshire. Not only does Buffett get timely updates on the economy, quite competitive with the information received by the Federal Reserve, but he also receives extremely valuable insight into particular industries, including some which are out of favor and thus candidates for investment. The Berkshire Hathaway Energy division run by Greg Abel has been a particular source of such information. Abel has made many bolt-on acquisitions. His extensive experience with energy transmission and storage assets enabled Berkshire's single largest capital commitment so far this year, the $10 billion cash-plus-debt-assumption acquisition of pipeline and storage assets for which Dominion Energy was, if not quite desperate, a highly motivated seller.

What's Your Edge?

Here are a few things Buffett's actions seem to be telling us:

Unless you have an edge, there are currently few opportunities in the US stock market either for making acquisitions or for buying shares.
Berkshire Hathaway itself is reasonably cheap and safe. Buffett makes buybacks at prices not accretive to book value but accretive to overall value.

Foreign investments may provide more opportunity at this time.
The small scale of his investments as a percentage of Berkshire's cash reserve signify his view that these are risky times in which cash may be needed unexpectedly, but you can expect better opportunities at some point in the future.

These are all implications of Buffett's action which may provide important food for thought for the average investor.

Should you try to piggyback the actions of Buffett? Certainly not in all cases. One can make the case for looking closely at the Japanese trading companies if dividend yield with modest growth are your primary objectives. I may attempt to write a short article about that, prompted by my ex-wife's query about which of them she should buy. At the present moment you can probably buy these sogo shosha for about what Buffett paid, although they have traded at times as much as 30% below the current price over the past couple of years. You'll just have to accept exposure to the Japanese currency, as you can't easily replicate Buffett's borrowing in yen. Currency hedging is expensive and not generally recommended in stocks although it sometimes makes sense with bonds.

As for Snowflake? It was risky even at Buffett's price, a risk which he and his lieutenants had clearly thought through. If you check the market, you will see that you and I cannot get anything close to Buffett's price. The value of Buffett's position more than doubled on day one. I doubt that he would buy it today. You and I shouldn't.

It's too bad we can't all take advantage of the kind of edges that Buffett often has available. We can from time to time look at mis-priced securities and buy them in the size that edge/odds calculation suggests. First, however, assess yourself and be sure you are aren't the type of better who bets the jockey's colors or the horse's name. Then ask yourself the basic question: what's my edge?

I would like to hear your thoughts on this question in comments.

*Buffett's racetrack and horse handicapping experience are from Alice Schroeder's Buffett biography The Snowball. Information on the Kelly Criterion and its application are from William Poundstone's Fortune's Formula and a variety of other sources.

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