The spirit of a holding company (part 1)

Ideas inspired by Caylen Cane (good friend and passionate student of investment practice).

Warren Buffet is a financial genius. He has generated Midas-like wealth for many hundreds of people through his investment holding company (Berkshire Hathaway), and arguably many multiples more as a result of his investment writings. Super smart, affable, witty, and a philanthropist, his is an example of an influential story in anybody’s book of life.

I will argue that the smartest investment decision Mr. Buffet made in his multi-decade career is not one that is often highlighted in the voluminous literature concerning him, but one much can be learnt from. Many South African investors have travelled the route Mr. Buffet has made famous, and I am of the opinion that many more should, at least in spirit. 

There are arguably three reasons why Mr. Buffet could be described as an investment master of the first order. I will touch briefly on the first two and unpack the third as the primary subject matter of this essay.

The first reason for justifiably describing Mr. Buffet as an investment great, possibly the greatest investment great, is his stellar investment record over many decades. Mr. Buffet is no flash in the pan. Somebody achieving the sort of financial returns over the extended period of time that he has done so is not lucky. No sir, nobody, bar none, is that lucky. On a normal distribution of returns he would be so far off to the right of the expected that the average market participant travelling at an average rate of return would require many financial lives to get within a decent proportion of his wealth.

The second reason augments the first, and arguably puts the nail in the coffin of those who would claim luck as the reason for Mr. Buffet’s investment record. Not only has he achieved superior returns over an extended period of time, he has also made multiple investment decisions in doing so. The number of largely independent, very successful decisions he has made, provides compelling evidence that he really knows what he’s doing and that he is not merely exceptionally lucky. For arguments sake, lets assume his achievements are due to chance alone. How would such an argument go?

Imagine yourself buying or selling shares at random (having no specific or good reason for doing so). A persuasive argument from probability could be made that you could have rivaled Mr. Buffet’s returns, for the simple reason that you could have bought shares of Berkshire Hathaway itself. One decision, to buy one stock, would have put you in the investment hall of fame as far as rates of return are concerned. The necessary and sufficient requirement for this return performance would have been nothing more or less than luck. In other words, history happened to unfold in such a way that you were able to acquire Berkshire shares at the right time. Perhaps you were a distant cousin of Mr. Buffet, or a resident of Omaha back in the day? Who knows? In other words, anybody could in principle have achieved the sort of financial returns that have made Mr. Buffet famous. This raises the question of whether Mr. Buffet himself owes his success to fortunes favour or to skill?

Noting that the argument from chance could be extended to show that it is possible that Mr. Buffet himself picked a stock at random supports the suggestion that Mr. Buffet owes his success to fortune. In other words, he could have picked some stock, call it A, from which his wealth was derived, thus riding on the coat tails of some other investor or group of investors who may or may not have done the same with some other stock B. The longevity of Mr. Buffet’s investment record is thus a necessary element of his capital allocation greatness but not a sufficient one.

As noted previously, what differentiates Mr. Buffet from the lucky coat-tailer is in the number of decisions he has had to make to achieve his record. For example, imagine someone predicting the state of technology 40 years from the present. One person may suggest the reality of flying cars. Another may warn against terminator-like artificial intelligence scenarios. Whatever the prediction, and everything else been equal, the person who makes a greater number of (largely) independent forecasts about a future 40 years from today, is taking a much bigger risk of been wrong. This is due to the fact that there will be much more for him or her to be wrong about. If you forecast that there is going to be flying cars AND that terminator will roam the streets, then the probability of you been wrong is equal to or greater than the person who merely envisions the reality of terminator. If you make a hundred predictions and another person makes ten, assuming the predictions concern largely independent events, and your accuracy matches that of the person making fewer claims about the future, the argument that you’re achievements are largely the result of luck smacks of implausibility, especially if the number of forecasts rise substantially.

In other words, what I am suggesting is that many people were lucky to invest in Warren’s holding company. But Warren himself would have to have been phenomenally (improbably) lucky to achieve the cumulatively superior outcomes he has given the number of largely independent decisions he has made.

Lastly, I am of the view that what makes Mr. Buffet the first among investment greats is principally the result of the original structure he created from within which he has built his masterpiece one investment at a time. If Warren Buffet did not situate his capital allocation practices within a structure allowing him access to permanent capital, he would probably be significantly poorer in wealth and fame than where he finds himself at present. Why? 

Berkshire is a holding company. A holding company is one example of a structure that provides permanent capital to the investor and I believe it has been one of the most important contributing factors to Mr. Buffet’s phenomenal success. What I mean by permanent capital is capital that is fully at the discretion of the investment manager. Permanent capital is funds that are FULLY at the discretion of the relevant investment manager. Nobody, bar a change in the law of the land, is able to withdraw or contribute capital to such a structure except at the discretion of the manager or executive/s occupying the relevant position as far as the structure’s capital structure is concerned. Mr. Buffet was very smart to situate his endeavours in a structure where he could do much as he pleased, and we all know how pleasing the result has turned out to be.

In contrast, the typical structure within which portfolio managers operate do not give them access to permanent capital, and hence do not provide them with FULL discretion over the investable funds under their management. One may assume that a portfolio manager running a typical unit trust has FULL discretion over the funds within the portfolio under her management, but this assumption would be wrong. The manager, even assuming that she has a FULLY flexible mandate, meaning she is able to buy any asset, at any time, anywhere, and in any amount, does NOT have full discretion over the capital within the fund.

Ultimately, the final say concerning the movement of funds in a unit trust is up to the investors in the fund, you and me. This is because investors are able to withdraw funds from a unit trust on short notice. The structural feature of most investment vehicles, the lack of permanent capital, creates formidable obstacles to long-term wealth creation. 

Firstly, it exposes the manager of the fund to the psychology of her investees. A purely rational strategy is to buy shares low and sell them high. The problem is that shares are low because nobody likes them. If nobody likes them, chances are high that the standard vehicles for buying shares, unit trusts, will also be disliked. Hence, when it the right time for the manager to buy shares she often has clients that want to withdraw money from her fund. Conversely, when the market is very expensive and people cannot deposit money fast enough, she should arguably be selling shares and returning excess capital to the very people now very much in love with her hot fund.

Secondly, it creates the incentive for investment managers to be birds of a feather. I reckon that the reasoning behind the herd-like behavior seen among many unit trust managers is something along the following lines; If I succeed conventionally I will attract funds, earn a bonus, and be praised. If I fail conventionally, I will earn a smaller bonus (!), blame my failure on unmanageable uncertainty, and probably keep my job.

On the other hand, if I succeed unconventionally, I will be interviewed on Moneyweb, and Huisgenoot will replace their Steve Hofmeyer interview with a piece on me where I will be asked to provide and explain my 3-point master plan for establishing world peace. There is also a good chance that my fund will be in greater demand than turkeys on Thanksgiving.

If I fail unconventionally, Magnus Heystek will write a scathing opinion piece on me wherein he will probably warn half of South Africa never to give me another R5. Additionally, a persuasive argument will be made why the few loyal clients that I have left should strongly consider declaring me investment anathema. I will have no income to pay my mortgage and will probably have to change my name. I will have to consider approaching the Guptas if I can find them.

To be continued…

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Buffet made his money as a private equity investor that happens to have a listed vehicle. This is worlds apart from a fund manager investing in listed equities.

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