Buffett's Sage Advice (Part II)

Warren Buffett’s advice is sound — But relies on Berkshire’s unique structure — Decoding his sage advice is required to invest like the best.

VIEW AS PDF

BUFFETT’S SAGE ADVICE (PART II)

Warren Buffett’s generosity in sharing his wisdom, combined with his lengthy track record, has resulted in a library’s worth of sage advice.

Like all investment advice, implementing Buffett’s recommendations can be a challenge. While many investors profess to invest like Buffett, in reality, few investors can follow Warren’s way. Ultimately, Buffett’s unique structure at Berkshire Hathaway provides hidden advantages unavailable to ordinary investors.

Hold Cash

"Insurers receive premiums upfront and pay claims later. ... This collect-now, pay-later model leaves us holding large sums -- money we call 'float' -- that will eventually go to others. Meanwhile, we get to invest this float for Berkshire's benefit." - Warren Buffett

Buffett, like most successful value investors, has outperformed by protecting capital in down markets. This feature has two key benefits. First, alpha is generated as benchmarks decline. More importantly, capital is available to reinvest at incredible valuations during market downturns.

So Buffett holds cash. While this strategy seems easily replicable for all investors, there is a hidden subtlety: Buffett’s cash isn’t his. Berkshire’s insurance float provides Buffett with low-cost cash to hold.

For an ordinary investor, holding up to 30% of assets in cash is a substantial drag on returns. Most long-only public market funds are prohibited from holding this level of cash.

Replicating Buffett’s downside protection therefore requires a closer focus on valuation. A fund without a cash buffer must be more aware of downside risk to ensure alpha generation in declining markets.

Avoid Leverage

"I’ve seen more people fail because of liquor and leverage – leverage being borrowed money. You really don’t need leverage in this world much. If you’re smart, you’re going to make a lot of money without borrowing.” - Warren Buffett

There is a second interpretation of Berkshire’s cash hoard. Insurers are viewed as “leveraged bond funds.” Since the cash provided by the float is not really the business’s, this money is (kind of) borrowed.

Borrowing cash to invest in bonds or equities is leverage. While Buffett is often maligned for his cash balance, in reality it is prudent to maintain substantial cash given the investment portfolio is effectively leveraged. Ultimately, Berkshire Hathaway’s returns have kept up with the markets, despite a high level of cash, because of this leverage.

Yet Buffett instructs us to avoid leverage. And yes, we should, given that we don’t have access to low-priced, long-term insurance float. We should also realize that Buffett’s fabulous returns, like those of many outstanding active investors, have been buoyed by leverage.

Quality Businesses Over Quality Management

"When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” - Warren Buffett

Buffett’s focus on quality businesses makes intuitive sense. Difficult, low return industries are a tough backdrop to overcome. But Buffett’s ability to prioritize business over management is a privilege few other investors have.

Berkshire Hathaway is essentially the world’s largest activist investor. While Buffett makes a point to operate in a decentralized manner, he retains the right to fire any CEO and, more importantly, demands that all capital be returned to him in Omaha.

Buffett astutely points out that “After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.”

The deployment of this capital is a key driver of investment returns. This makes the management team essential for any investor that cannot simply demand all capital be returned. Regardless of the economics of a business, the investment will fail if the management team squanders capital.

Buffett enjoys a massive advantage by retaining control over all capital allocation decisions. For the average investor, an evaluation of management’s ability to deploy capital should be a top focus.

Wait for Mr. Market

“Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.” - Warren Buffett

Buffett enjoys a special relationship with Mr. Market. Specifically, when markets are in turmoil, Berkshire’s stamp-of-approval is immensely valuable and Buffett is able to cash in on his reputation.

Examples include Buffett’s deals with Goldman Sachs and Bank of America during the Great Financial Crisis. The average investor was not offered preferred shares with high dividends and valuable warrants.

This benefit does not only arise during crises. Good management teams want to be associated with Berkshire Hathaway. Given Buffett’s track record, swapping business assets, even at a discount, for Berkshire stock may be a rational move.

Investors should be patient when waiting for the market to offer attractive buying opportunities, however, investors must also be more proactive. The average investor’s phone doesn’t ring with leading businesses asking for capital in market crises!

Replicating Buffett’s Returns

Buffett is an inspiring value investor, but those looking to follow in his footsteps must adopt different practices to replicate his success.

Buffett’s wisdom must be adjusted for use by the average investor, specifically when it comes to managing cash holdings, using or avoiding leverage, evaluating management teams, and waiting for Mr. Market.

While Buffett does not intend his advice to be enigmatic, understanding the context in which Berkshire Hathaway operates is essential to decoding his sage advice.