With Warren Buffett's annual celebration last weekend and some grumbling about his failure to beat the market in four of the last five years, people keep reminding me of a piece I wrote in 1996 for Dow Jones about Buffett's portfolio. They ask what adjustments I would make to that analysis, in which I suggested that one way of looking at the Berkshire Hathaway holdings was as a "Common Joe" portfolio.
Though many books have been written about Buffett's investments, mine was a short take. Mr Buffett himself has pointed out that he doesn't disclose his ideas because good ideas are rare. So, commentators have been left to speculate: Some
have claimed that he buys into brands; others have emphasized a knack for spotting mispricing - something Mr Buffett agrees with. He once noted that stock prices signal to him that other investors are doing foolish stuff. He then steps in and starts to correct the (about) 30% mispricing, a number he has been citing.
Still others have insisted that he invests in producers of low-priced brand-name goods or services that people buy even during hard times. Some academics have chalked it up to luck. After all, the laws of probability don't exclude heads coming up 40 times in a row - though this argument doesn't hold up under closer scrutiny.
So, almost 20 years ago, I shuffled the Berkshire Hathaway portfolio in search of a pattern, and this is what I found. Information can be organized in only five ways: location, alphabet, time, category, and hierarchy. I quickly dismissed options of perceiving the portfolio through location, alphabet, hierarchy, and brand-name categories. That left me with only one way to try and find a pattern: time. My hunch wasn't random: I had a prejudice toward time, knowing that it's the only notion that can be linked with the magic of compounding.
The question then became: compounding in what sense? I stumbled upon an answer when looking at the holdings in this particular order: Gillette, Washington Post, Dairy Queen, McDonald's; now add Heinz, a well-known UK doughnut business, Coca-Cola, candy companies, Guinness, Capital Cities/ABC-Disney, Federal Home Loan Mortgage Corp, MidAmerican Energy Company, Geico, US Air, Wells Fargo, American Express, Salomon Brothers, furniture, shoes, and jewelry.
How was this ordering linked to time and compounding? Well, one gets up in the morning and shaves (Gillette); reads the newspaper (Washington Post); eats breakfast (Dairy Queen, McDonald's); buys lunch (McDonald's/Heinz ketchup), a drink (Coca-Cola/beer), and a sweet snack (candy, doughnuts). In the evening, one gets a drink (Guinness) before settling down to enjoy some entertainment (Cap Cities/ABC-Disney).
During a lifetime, people live in houses (Federal Home); heat them (MidAmerican), take out car insurance (Geico); travel (US Air); need a good bank (Wells Fargo), credit card (American Express), and investment advice (Salomon Brothers, maybe). Add furniture, shoes, and jewelry, and you've got a portfolio that reflects roughly the main spending patterns during the average day and average life of the average Joe, fitting an image that Buffett has been so good at cultivating.
As the "average Joes" get richer or there are more of them, the portfolio would do well - time and compounding at work. The above idea appears to be simple in principle. At least it significantly narrows down the choices for the portfolio, though one still must be able to choose well among competitors, as well as the timing and pricing, and consider whether or not the "common Joes" are still growing and whether or not there are any significant changes in what defines these "common Joes".
There are Berkshire Hathaway holdings that contradict this simplistic view, such as owning General Dynamics (submarines, tanks, aircraft); buying significantly into silver at one time; or, more recently buying into metal-cutting tools (Israel's Iscar) or chemicals (Lubrizol). But, at least in regard to General Dynamics, Buffett acknowledged that the purchase was accidental, though he later decided against selling. Accidents happen, and there's place for luck and opportunism in the life of common Joes, too.
Mr Buffett has been financing his deals from the floats of insurance companies and borrowing. But to successfully manage insurance companies, there are two options. Either the management is good at pricing insurance policies - a tough job in which Buffett again, by his own acknowledgment, made many mistakes. Or the management may be good at allocating the capital from the premium. Buffett turned out to have superior skills in the latter, covering for the occasional mispriced insurances.
As for his accumulation of silver less than 20 years ago - a trade which, by his own admission later, brought him lousy returns - I speculated in that 1996 piece that it may turn sour. Buffett appeared to have jumped massively into the silver business upon his return from China, a country that was on the silver standard for centuries (using the Mexican silver dollar) and returned to it repeatedly after short departures (during which China experienced high inflation).
When it was announced that Buffett accumulated silver, the price went up from US$4 to $7 dollars per ounce. But time went by, and no country moved back to a metallic standard (be it gold or silver); the then Federal Reserve chairman Alan Greenspan didn't officially announce either that the commodity price index would always be a component in guiding his monetary policy (though in his testimonies he did refer to both this index and gold repeatedly, and Manuel Johnson, his vice chairman, published a book in 1996 recommending the Fed be guided by such an index and not the Consumer Price Index). The price of silver dropped and hovered around $5.
Since adhering to a metallic monetary standard is a political decision, Buffett perhaps miscalculated - if, indeed, China's history was his inspiration to get into silver. Perhaps Buffett will reveal something about that decision in his memoirs. Though it does appear that when significant monetary and exchange rate changes happen, which are political matters, Buffett appears to have no good insight, whether it was about silver or Canadian investors.
Indeed, over the past 10 years, investment in Berkshire would turn out to be a bad decision for Canadians. The Canadian dollar over this time span went up by more than 50% relative to the US dollar. Berkshire stood at around US$90K in 2004 and is now at US$190K. If someone bought one share in 2004, when one Canadian dollar was at $0.70 US dollar, he would have paid about $128K in Canadian dollars for it. If he held it until today, he would have received a return of 48% for the last 10 years, which is 4% per year.
Which brings me to the present: railroads and specialized railway cars are significant Berkshire holdings, too. These companies are the backbone of "material" distribution, with highways and airways its competitors. In contrast to the latter two, though, the barriers to entry are more significant. Buffett has shunned the digital highways and the tech companies linked to this distribution channel (Microsoft included), which deliver the digital items to today's common Joes.
Will Buffett misread the spending patterns of the "new" common Joes? Or is he right in not perceiving long-lasting uniqueness in any of the companies using the digital distribution channels (though Microsoft, Google and Apple are three of the four largest US companies by market valuation, and the use of the latter two define the new "common Joes")? Or does he believe that the demand for "material" stuff will always be there and prove to be more stable (you can't survive on digits, right?)? Time will tell.
Reuven Brenner holds the Repap Chair at McGill's Desautels Faculty of Management, serves on the Board of McGill's Pension Fund, and is a member of its investment committee. Brenner's last book is World of Chance (2008).
This article was originally published on www.minyanville.com. For the original, see here. Republished with permission.