Who Is Your Portfolio Manager (or CEO)?

Many college campuses have what is called a “Greek System,” where groups of men and women gather together in organizations called fraternities and sororities. While sometimes (okay, rarely) the aim of these organizations is philanthropic, more often than not it is an entirely social endeavor. While this has the potential to give certain 20 year olds an outlet of sorts (usually negative), or probably more poignantly a group of “instant friends,” it also offers the opportunity to observe how large groups of folks tend to think, and can also be construed as an early-age microcosm of Corporate America.

In most fraternities—or hell, any large organization of people--decisions are typically made by what is deemed to be the most popular or accepted among the majority of members. One or two folks will first throw an idea or two out there, which will tend to be safe ones, as they typically don’t want to offend anyone. This will then serve as the anchor, as almost all other ideas will tend to be a modified version of the first few. The ideas will then be narrowed down and analyzed not on a rationale basis where one examines the potential outcomes (both positive and negative), but rather on who the sponsor of the idea was (popularity contest in a way), or what people believe is the safest and least offensive of the ideas. This, my friends, is what is called “groupthink.”

Maybe in college where some folks seek a sense of belonging above all else, groupthink actually serves its purpose of making people feel like they are bound together in some way. But in almost all other aspects of life, groupthink often produces the safest--and worst--possible outcomes of decisions for almost any organization. If we take most larger investment management—or almost any financial services—organizations as an example, each management, investment, or strategy decision is often made for the benefit of the person making the decision, not the strategy, not the organization, or most importantly, not the client. And if you need proof of this, just observe how many large organizations tend to have both average performance and average clients.

It’s so odd to me that people and organizations, while of course stating that they want to be the best (sounds good, doesn’t it?), are really through their actions trying to be average. Like all things, though, there is a silver lining. For some folks that have the ability to think rationally and independently, they can constantly exploit this drive of large bodies of people to be average, by having the freedom to make rationale, and often unpopular, decisions. And if you need proof of this too, just look again at the investment industry, and ask yourself why so many smaller and independently owned investment management firms have both the performance and clients that continually trounce the performance of the big name brands, where groupthink is so much more prevalent.

But there is another element to this story that also ties right back into college life. The person in most fraternities, and later in life in corporate organizations, that is administering these decisions is the president of the particular organization. And while I readily acknowledge that some presidents have genuine and strong leadership skills (typically from battlefield promotions—no popularity contest there), the majority of presidents are people that are generally likeable, and not offensive in any way. Said another way, they are often not the smartest, not the strongest, not the best leader, but the safest person who relies on groupthink to make decisions.

In college fraternities, they tend to be the person who doesn’t say much, doesn’t have many opinions, has a cherub face with smile, and drinks a lot. Ironically, these are the same people that are often CEO’s or highly compensated portfolio managers at larger organizations. Their skill is not in running an organization or client assets, but just bumping along and not offending anyone, which I might add is the key to getting promoted. And if you need proof of this, just look at how many moronic financial services company CEO’s—and portfolio managers for that matter—were forced out in the last year in the market downturn. They had no idea what was going on or how to lead, they were just the least offensive one living by groupthink and sitting in the chair.

So when you are examining your financial managers, it might behoove you to look for people who have real opinions, and have the emotional temperament and confidence to make unpopular decisions, rather than just the guy that smiles and most everyone seems to constantly pat on the back. He just might be your typical fraternity president.

You might also be interested to know that this blog was mentioned in a Reuters article, which I have linked here, and a Bloomberg article, which I have linked here.

I welcome dialogue with my readers so please do send me any questions or comments you may have.

Justin

Copyright © 2009 BuffettInsights

The content contained in this blog represents the opinions of Mr. Fuller. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business. This content is intended solely for the entertainment of the reader, and the author.

Do You Believe In Magic?

In the Old West certain salesman would travel by covered wagon from territory to territory selling oils, potions, and other elixirs. They hailed their products---which apparently they only had the recipe for—as cure-alls for almost anything that bothered the average frontier settler. It took not long for many folks back then to realize that these “salesman” were, in fact, praying on peoples’ fears and emotions to simply make a buck or two. They were quickly labeled “snake-oil salesmen,” and often run out of town soon after they arrived.

As I think through the last year or two, which included the fire sales of Bear Stearns and Merrill Lynch, the failures of Lehman Brothers and Washington Mutual, and the nationalization of Fannie Mae, Freddie Mac, and AIG, could it be that the financial services industry simply got chalked full of modern day “snake-oil salesmen” who only wanted to make a buck or two off of their clients?

Think about it. Many folks—aspiring first-time homeowners (frontier settlers in a way)—were conditioned to believe that homeownership--at whatever the cost--was one of the only ways that they could fulfill their American Dream. Thus, up from the dust, arose a group of enablers that sold people things that these folks didn’t have a chance of understanding, which didn’t even matter to the purchasers, because their emotions told them they were so close to achieving their dreams. Option-arm’s, pick-a-payment mortgages, and CDO-Squareds, to name a few were all modern day forms of snake oil. The only difference was that unlike the Old West, nobody seemed willing to run these enablers out of town.

Now that the financial system has come back from the proverbial abyss, it would seem that the resultant shakeout should have thrown a lot of these salesman out of the industry, or at least forced others to run them out of town. Perhaps this has occurred in the mortgage industry to some extent, but in other aspects of the financial services industry, these “snake-oil” salesman are as strong as ever.

Let’s take the hedge fund or investment industry as an example. Anyone who takes the time to sit down and read seminal books like Security Analysis and The Intelligent Investor, or even better, the writings of Warren Buffett, should quickly realize that investing is not rocket science. Running the basic numbers, making conservative projections, and valuing and learning about various businesses is not overly difficult, though it does require long hours of reading. What is more difficult about investing, but not impossible, is having the emotional temperament to think and do things independently, and to wait for attractive prices.

While it seems so simple, I rarely hear any investment manager explain what they do in such clear—and understandable—terms. Instead, I hear not all, but many explain that they have a proprietary market model, or that they have spent decades developing a black box that crunches numbers, or that they are currently pursuing a leveraged beta trade (whatever that is), to name a few of the forms of “snake-oil” currently being promoted. What’s more, many further purport that they are the only ones who could have developed these so-called magical tools for creating wealth. Sounds a bit like the Old West now, doesn’t it.

What is even more surprising, though, is that legions of folks seem to blindly buy into this marketing stuff without ever being skeptical. It is as if you can envision a group of folks huddled around the lunch table (covered wagon), eyes glazed over, taking in everything the salesman says as gospel. But to be fair, even if these folks are skeptical, they typically don’t ask poignant questions about what some of these managers really do. Perhaps they are scared to do so, or perhaps they just believe the purported magic of these promoters at face value.

Unfortunately, there is no sure fire way to ferret out what is snake oil or what is legitimate in the investment industry. One thing to think about, though, is that if there is something that you don’t understand after it is explained to you, ask yourself if it sounds like “magic”, and if it does, send the promoter off in his covered wagon in a cloud of dust.

You might also be interested to know that this blog was mentioned in a New York Times article, which I have linked here.

I welcome dialogue with my readers so please do send me any questions or comments you may have.

Justin

Copyright © 2009 BuffettInsights

The content contained in this blog represents the opinions of Mr. Fuller. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business. This content is intended solely for the entertainment of the reader, and the author.

Berkshire Remains Busy

Berkshire Hathaway recently released its second quarter form 13-F, which details the investment conglomerate’s domestic equity holdings as of the end of June 2009. And in this last quarter, Berkshire has continued to be active by selling positions in some holdings, as well as adding a new name to the portfolio.

It should be noted that in last week’s second quarter earnings report, it appears as though Berkshire has been more active in purchasing fixed income securities—primarily international ones—than equities. That said, it is still instructive to monitor Berkshire’s holdings to try and gauge changes in the conglomerate’s thinking. It should also be mentioned that Berkshire does receive exemptions from the SEC to disclose some of its positions, until the conglomerate is able to build a full position in a particular stock.

New Names and Additions

In the last quarter, Berkshire added shares of medical technology company Becton, Dickinson and Company (BDX), which adds yet another healthcare related business to Berkshire’s equity portfolio. And on this front, Berkshire has continued to build back up its position in another healthcare related company, Johnson & Johnson (JNJ), which it was forced to sell some of late last year in order to raise capital for other investments.

In my opinion, each of these moves is noteworthy, as there seems to have been a subtle move towards healthcare and pharmaceutical companies in Berkshire’s portfolio over the last couple years. It is impossible to know for certain Berkshire’s thinking, but if I were to conjecture, I don’t necessarily think it is a favorable top down view of the healthcare sector on Berkshire’s part. Rather, in my view, it could be that many of those businesses have very strong franchises, and have seen their share prices decline as a result of the political uncertainty regarding healthcare reform.

Eliminations and Subtractions

There was only one complete elimination from the portfolio, which was the shares of Constellation Energy (CEG), which Berkshire received as consideration when Constellation pulled out of a deal to be acquired by Berkshire subsidiary Mid-American Energy. Berkshire has been selling its position in Constellation since the beginning of the year, which also had the effect of posting nice gains in Mid-American’s second quarter earnings.

As for the subtractions, Berkshire continued to sell its position in used car retailer Carmax (KMX) during the second quarter. Carmax’s business likely continues to struggle as new car companies liquidate inventories of new cars with the help of both company and government incentives.

Berkshire also continued to sell some of its stake in UnitedHealthcare (UNH), Wellpoint (WLP), Home Depot (HD), Eaton Corp (ETN), and integrated energy company ConocoPhillips (COP). As for Conoco, Berkshire indicated that it sold even more shares since the end of June. These Conoco sales will likely produce realized losses, which Berkshire can use to shield future gains from taxes.

While not showing up as a sale in the second quarter, Berkshire subsequently has also indicated that it has trimmed its position in bond rating firm Moody’s (MCO), which I don’t think is overly surprising given that the reputation of the bond rating firms is effectively on life support right now. That said, Berkshire still owns about 17% of Moody’s.

Unchanged Positions

The bulk of Berkshire’s equity portfolio was unchanged from the prior quarter. Here is a listing of those names:

• American Express (AXP)
• Bank of America (BAC)
• Burlington Northern (BNI)
• Coke (KO)
• Comcast (CMCSA)
• Comdisco (CDCO)
• Costco (COST)
• Gannett (GCI)
• General Electric (GE)
• GlaxoSmithKline (GSK)
• Ingersoll-Rand (IR)
• Iron Mountain (IRM)
• Kraft Foods (KFT)
• Lowes (LOW)
• M&T Bank (MTB)
• Nalco Holdings (NLC)
• Norfolk Southern (NSC)
• NRG Energy (NRG)
• Procter & Gamble (PG)
• Sanofi Aventis (SNY)
• SunTrust Banks (STI)
• Torchmark (TMI)
• US Bancorp (USB)
• United States Gypsum (USG)
• Union Pacific (UNP)
• UPS (UPS)
• Wabco Holdings (WBC)
• Wal-Mart (WMT)
• Washington Post (WPO)
• Wells Fargo (WFC)
• Wesco (WSC)

You might also be interested to know that this blog was mentioned in a Bloomberg article that I have linked here.

This and That

Also, if you haven’t already done so, please be sure to register before time runs out for the first “Late Summer Buffett Conclave” (www.buffettconclave.com), which is a social and networking event on August 28th in Chicago for folks interested in Berkshire. We already have a great group of attendees, and still have space to fit in a few more "Buffettologists." Disclaimer: Neither Mr. Buffett nor Berkshire Hathaway nor any of its employees are affiliated with this event.

Justin

Copyright © 2009 BuffettInsights

The content contained in this blog represents the opinions of Mr. Fuller. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business. This content is intended solely for the entertainment of the reader, and the author.

Berkshire Grinds Out 2Q Earnings

Berkshire Hathaway reported second quarter earnings Friday that were largely mixed. While the headline number showed an improvement, that was largely due to gains in some of Berkshire’s derivative contracts, which are non-cash and tend to create more volatility in the conglomerate’s quarterly earnings. Including these derivative positions, though, Berkshire’s second quarter earnings grew 14%.

In the operating businesses, the story was more mixed. The insurance businesses produced satisfactory results, though underwriting profits were mostly down. While auto-insurer GEICO continues to attract new customers seeking cheaper auto-insurance, its underwriting profits were down thanks primarily to higher losses. General Re improved its profits, while Berkshire Hathaway Reinsurance and the primary insurance group saw declines in profitability.

Berkshire did indicate in its quarterly report that it is more willing to take on large exposures than it was earlier in the year, but that it hasn’t yet as industry wide pricing continues to be very competitive. Berkshire’s total insurance float—premiums collected and not yet paid as claims—increased to $61 billion as of June 30. This additional float—as well as preferred stock dividends from GE and Goldman Sachs--helped boost investment income in Berkshire’s insurance operations by a strong 18%.

The utility business earnings also held up okay, despite large revenue declines attributable to both weak demand and lower prices. The results in the utilities did benefit from gains in the stock of Constellation Energy, which Berkshire received as consideration when Constellation pulled out of a deal to be acquired by Berkshire subsidiary Mid-American. If not for these stock gains, Berkshire’s second quarter earnings in its utility businesses would have been down about 7%.

Results in the operating businesses were down more substantially, which wasn’t entirely unexpected, given the revenue and earnings weakness reported by many other similar businesses over the last few weeks. Across the board revenue was down between 20-30% in most of Berkshire’s operating businesses. NetJets revenue was down even more, at 43%, as that business continues to be flat on its back. In addition, NetJets also had a CEO change in just the last week. The one area that held up, and actually showed some modest growth, was McClane (a foodservice provider), which posted an 8% increase in revenue versus the prior year quarter.

Berkshire’s investments recovered somewhat, which helped push the conglomerate’s book value per share up 11.4% during the second quarter. Berkshire’s cash balance now sits at about $21 billion, after its flurry of investment activity over the past year. Berkshire has indicated in the past that it likes to keep at least $10 billion of cash on hand for insurance regulatory purposes, and given the current economic environment, it would seem that Berkshire would want to keep even more cash on hand. As such, if Berkshire were to make an additional investment or acquisition it would probably raise some additional cash to do so by potentially selling some marketable securities, as the conglomerate has already done over the last six months.

You might also be interested to know that this blog was mentioned in an Associated Press article that I have linked here.

This and That

Also, if you haven’t already done so, please be sure to register for the first “Late Summer Buffett Conclave” (www.buffettconclave.com), which is a social and networking event on August 28th in Chicago for folks interested in Berkshire. Disclaimer: Neither Mr. Buffett nor Berkshire Hathaway nor any of its employees are affiliated with this event.

Justin

Copyright © 2009 BuffettInsights

The content contained in this blog represents the opinions of Mr. Fuller. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business. This content is intended solely for the entertainment of the reader, and the author.

Management Change at Berkshire Subsidiary NetJets

On Tuesday, it was reported that NetJets’ CEO Richard Santulli was stepping down from his post and would be replaced by David Sokol, former head of Berkshire subsidiary Mid-American, on an interim basis. This announcement was interesting on a couple of fronts, as Santulli had spent 25 years at the company he founded, and to step aside during a difficult time for NetJets was surprising. Secondly, Berkshire hasn’t typically moved executives around to run its different businesses, instead typically promoting from within each business, anytime succession has cropped up at the subsidiary level.

In my opinion, this announcement can be viewed from two different viewpoints. It could indicate that NetJets doesn’t possess the internal candidates that the Berkshire brass believed would be right to lead the organization at this juncture, and as a result, Sokol has stepped in until the right candidate could be identified. If this is indeed the case, it will be interesting to watch how Berkshire handles this, as there will likely be further subsidiary company successions in the coming years, as several of the folks running Berkshire’s other businesses are nearing retirement themselves.

The other way to view this announcement, is that it is yet another vote of confidence by Berkshire in Sokol, who many believe may be one of the leading candidates to eventually replace Chairman Warren Buffett as the operating CEO of Berkshire. Furthermore, this would give Sokol additional experience in running another of Berkshire’s businesses, which would seem to strengthen his qualifications.

Whether Sokol stays on at NetJets for the long haul, or if a different internal or external leader is ultimately identified, this move seems to be a very smooth way to handle succession at NetJets, where the business is likely facing a number of headwinds given the presently weak economic conditions.

You might be interested to know that this blog was mentioned in an Associated Press article, which I have linked here.

This and That

Berkshire is due to report earnings this Friday, so please check back this weekend for my analysis of Berkshire’s second quarter results.

Also, if you haven’t already done so, please be sure to register for the first “Late Summer Buffett Conclave” (www.buffettconclave.com), which is a social and networking event on August 28th in Chicago for folks interested in Berkshire. Disclaimer: Neither Mr. Buffett nor Berkshire Hathaway nor any of its employees are affiliated with this event.

Justin

Copyright © 2009 BuffettInsights

The content contained in this blog represents the opinions of Mr. Fuller. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business. This content is intended solely for the entertainment of the reader, and the author.

What is Asset Allocation?

There is an old saying, that if you do the little things right, the big things will take care of themselves. And in almost every case, from a football team driving towards a championship season, to a fledgling business trying to gain customers, does this maxim usually prove correct. Then why, one might ask, in the investment world do most professionals focus most of their time on trying to make the big decisions?

Several years ago, there was a bunch of research done that suggested that most folks’ investment returns were primarily determined by which assets or sectors they allocated a percentage of their capital to. And like the light of a match, people started trying to determine what their “optimal asset allocation framework” should be. They posited that maybe it should be 60% stocks and 40% bonds, or 50% towards healthcare companies and 50% towards commodities, or 20% in cash and 80% in real estate, and well you get the idea, this list goes on. The thinking was, that if you get the exact percentage of each asset class right, it wouldn’t matter so much what the individual investments actually are.

And while I’d probably agree that methodology of this research was likely done with solid empirical backing, I’d argue that the conclusions drawn from it were entirely backward. To me, at least, it seems impossible to determine the exact percentage of one’s portfolio that should be invested in a particular asset class, no matter how much data analysis one does. Nor is it feasible to determine in which asset class, in fact, the money should be invested.

The problem was that most folks’ conclusions were that the most important thing to do was to make big top down decisions about how they wanted to invest their money. I’d argue, on the other hand, that this asset allocation research should instead be interpreted as the outcome of continuously searching for reasonably priced individual investments. And if one starts finding good investments (which can tend to cluster in the same assets or sectors), their portfolio will exhibit a certain “asset allocation framework,” but it will be arrived at by finding good investments, rather than drawing a line in the sand and deciding how the assets should be allocated.

The difference in these interpretations is dramatic. One viewpoint (the top down one) compels action. The other, (the outcome one) educates the investor about what her portfolio actually looks like. And to me, at least, education almost always trumps action.

The bigger implication of this “outcome” viewpoint, though, is that the individual investments do matter. There are thousands of stocks and thousands of bonds, and by just saying that you have 60% of one basket and 40% of another, says nothing about the quality of your portfolio. If, on the other hand, one finds good and understandable investments at reasonable prices, that investor will do just fine, regardless how someone else labels their investments. Just like the old saying above implies, by focusing on the individual investments in your portfolio, your larger “asset allocation framework” will eventually take care of itself.

I welcome dialogue with my readers, so please send me any questions and comments you have. Also, if you haven’t already done so, please be sure to sign-up for my free email alerts by emailing me at BuffettInsights@gmail.com.

Justin

Copyright © 2009 BuffettInsights

The content contained in this blog represents the opinions of Mr. Fuller. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business. This content is intended solely for the entertainment of the reader, and the author.

Does Diversification Make Sense?

If you were to go to a restaurant today and order some food, would you order one of everything on the menu, or would you just order a few of the things you really knew that you liked? Chances are—and I might be taking a big leap here—that you would know what you liked for whatever reason (taste, healthiness, price), and would order just a few of those things, rather than thinking you had to have one of everything on the menu. Maybe I’m in the minority here, but that course of action seems to make the most sense to me.

Yet in the investment world, most folks seem to be encouraged to have one of everything off of the proverbial financial menus that larger financial firms offer. The reason typically given for promoting this type of behavior, is that the more investment products one has, the more that person’s portfolio is diversified. This assumes, of course, that diversification is something that should be universally desired among all investors. But does this really make sense?

At first blush, diversification seems like a good idea. In theory, when one investment declines in value, another less correlated investment should tend to rise in value, leaving the investor’s portfolio somewhat unchanged. While this should generally make folks feel better about their portfolios, to me at least, it doesn’t make a lot of sense from an investment perspective. For example, if the aim of a diversified portfolio—a likely moving definition—is to protect investors on the downside, the natural corollary to this, is that investors are giving up the potential for gains as well. And if an unchanged portfolio is the typical outcome of a diversified portfolio, why pay the huge fees of various investment products sold by larger firms? Why not just hold cash?

But I think that in some cases that this “diversification” mantra can be even worse than only holding cash. How many of your portfolios were supposed to be fully diversified over the last year, and even so, they are now worth 40-50% less than they were two years ago? Not much of a ringing endorsement, if you ask me. In times of crisis—just when diversification is needed most—all the correlations of the different investment products tend to converge to one, thereby reducing an investor’s downside protection. In this case, folks would have even been better off holding cash, and what’s more, they wouldn’t have had to pay all those fees to their “financial advisors”—a euphemism for sales person--for their various investment products.

A couple of years ago at the Berkshire Hathaway (BRK-A) annual meeting, an attendee asked Berkshire Vice-Chairman Charlie Munger a question about the merits of diversification in investing, and Munger sagely advised, “The whole secret of investment is to find places where its safe and wise not to diversify.”

If one thinks about this, what Munger is actually saying is that the notion of diversification--as most “financial advisors” interpret it--is nothing but hogwash. Rather, the advice he is imparting in the first part of that statement is that investors should search for a few businesses or securities where the margin of safety is so great—or said another way, the price is so low—that it is highly unlikely for an investor to lose money. Downside protection, in this case, is not contingent on a group esoteric correlations, but rather by the price you pay for a particular investment.

In the “wise” part of the statement, Munger is implying that if you can find a few investments with upside potential, where you understand the business or security so well that you have an edge over others, it would behoove an investor to make that a larger investment in their portfolio, as long as the price paid for the investment has a large enough margin of safety.

And, in my opinion, this approach to investing espoused by Munger is actually better than even diversification in theory, as it gives investors both downside protection as well as the potential for huge upside for their portfolio.

My best wishes to you and yours for a happy and safe Fourth of July holiday.

I welcome dialogue with my readers, so please send me any questions and comments you have. Also, if you haven’t already done so, please be sure to sign-up for my free email alerts by emailing me at BuffettInsights@gmail.com.

Justin

Copyright © 2009 BuffettInsights

The content contained in this blog represents the opinions of Mr. Fuller. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business. This content is intended solely for the entertainment of the reader, and the author.