Channeling Warren Buffett

by William Smead, Smead Capital Management

The most popular missives we write are associated with Warren Buffett’s annual letter to shareholders and the annual shareholder meeting in Omaha. This year we thought it would be fun to channel Mr. Buffett and attempt to write his letter for him. In effect, our goal is to predict what matters to him as a portfolio manager of private and public businesses. Buffett’s favorite holding period is forever, so predicting and guessing what matters most to shareholders doesn’t change much from year-to-year. We do this with our tongue in our cheek, knowing we could be left with a bit of egg on our face:

Dear Shareholders,

As we finished the year 2018, we were reminded that stock market setbacks and declines (like the one in the fourth quarter of 2018) are the friend of the long-term investor. My teacher and mentor, Benjamin Graham, liked to say, “In the short run, the market is a voting machine and in the long run it is a weighing machine.”

We are very proud of our portfolio of companies and when it comes to financial strength and quality of management, we’d like to think it is second to none. A stronger economy in 2018 helped us in our railroad, utilities and industrial entities. Some of our financial holdings, like banks, suffered from some temporary popularity early in the year, that in turn opened the door in December for lower prices and opportunity to those of us who think their future is bright to purchase more shares. God didn’t help us in the weather and catastrophic event categories, so our insurance business definitely had their ups and big downs.

Use of Massive Cash Hoard

While we remind everyone that we are looking for whole companies who would like an exit strategy for large holders and founders, those have been hard to come by in recent years. This is a function of big private equity premiums being offered from an industry drunk with cash and from a stock market which has rewarded the kinds of businesses we’d like to own. We will maintain patience on the whale-hunting expedition and point out that our phone sits waiting to be rung by an entity which fits our criteria for company selection. Someone should tell the folks at Aflac (AFL) that we would love to own the duck and manage their massive float.

On the other hand, the bifurcation between popular companies in the more futuristic parts of the stock market and important/more traditional businesses like banking, insurance and credit cards have led us to up the ante on JPMorgan (JPM) and American Express (AXP). I can’t rave enough about Jamie Dimon and his annual letters and I am very glad he’s not big on sending text messages. At last year’s annual meeting, we explained how impressed we are with the job Ken Chennault and his team have done at AXP. Like Charlie always says, “buy a great business at a reasonable price.” American Express is a great business and it looks more than reasonable. We think they have one of those mirrors on the wall that says to go ahead and raise prices now.

Buying back our own stock seems compelling vis-à-vis the current depressed valuation, but Charlie and I want to save most of that firepower for buying shares when one of us has a health issue relating to our advanced maturity. My cheeseburgers and cherry cokes are going down smoothly as always, but I am about to turn 89 years old and Charlie is about to pass Methuselah! Therefore, when that inevitable day comes, we want our successors to have buying guns loaded.

Equity Valuations

I hate to sound like a broken record, but the 10-year Treasury bond interest rate makes owning common stocks look like a dream, even ten years into a rising market. We bought more Bank of America (BAC), JPM and AXP at multiples of 10-13 times after-tax profits and envision the largest adult population group (millennials) beginning to seriously engage these financial institutions in higher margin lending and services. These circumstances make our over-developed greed glands salivate. This aging process should push economic growth and ultimately could cause interest rates to normalize. Someday, these millennial folks will look back at the early years of their adulthood (age 27-35) and feel blessed by historically low interest rates and very affordable housing everywhere other than where they wanted to live in their extended childhood (age 20-30).

Insurance

Our results in the insurance area are very lumpy and that will never change as we are required to mark results to the market. We want you to know that Ajit Jain is a genius and he can separate people from their money in the insurance business as well as almost anyone ever has. The float created effectively means we have been owning stocks with free leverage for decades and our massive balance sheet dwarfs any of our competitors.

With this kind of crushing dominance, it is easy to understand why we sit by watching Amazon, Facebook and Google monopolize e-commerce, social media and search. If the government will leave us alone and bathe Berkshire in tax subsidies at MidAmerican Energy, while allowing me to personally avoid taxes, why should I say anything? The fact that we are in the process of creating the most unequitable economy this side of 1900 will probably be an issue worth discussing once our run at Berkshire Hathaway (BRKA/BRKB) is over!

Apple

We were eight years late getting into Coke (KO) stock in 1989 (it bottomed in 1981-1982), but we did get a ten-bagger from 1989-2000. I bragged about it in 1998 and forgot that someone smart said, “when you want to brag about a stock you should sell it.” Coke has massively underperformed the S&P 500 Index since then, but we are cheap and hate to pay any taxes. Instead of selling, we have promoted the brand and their stock for 19 years. The fact that Pepsi has run rings around us in the snack business the last twenty years and their stock has soared in comparison to Coke, only bothers us when we think about it. We feel the same way about Apple’s shares now that we felt about Coke in 1989. They are a dominate brand and have unbelievable control over affluent folks, especially in the U.S. Charlie and I can look ten years down the road and see nothing but higher and higher free-cash flow.

We know that some of you are looking at Apple and thinking, where was I ten years and five years ago? The answer was I was busy working on IBM and going back to my deep value days. It is always good to humiliate yourself occasionally and all of us do it in the stock picking realm. Since we run a closed-end company, nobody can take the money away from us and Vanguard can’t take our business away. I am thinking of signing on to be the new wholesaler in-chief for index investing. I’d like to get people down to two choices, indexing or BRKA/BRKB.

U.S. Economy

A few years back, I wrote that if I were a young man I’d buy five houses, fix them up and rent them. Berkshire Hathaway is an all-in bet on the American economy and you shouldn’t let the prognosticators scare you out of long-term ownership of it. Charlie and I will remind you that if your company has an economist on staff, you have one too many employees. Economists have been very busy lately, mostly with scare tactics. Looks like these economists don’t like President Trump. We like any President who leaves us alone and allows us to personally avoid meaningful income and estate taxes.

The next ten years are likely to be great. Towns like Omaha should be major beneficiaries of couples looking for affordable places to live and raise a family. We own many direct participations in expanding and improved home ownership, including Clayton Homes, Berkshire Hathaway Home Services, Benjamin Moore, Shaw Carpet and others. I dumped our home on the California coast recently because we weren’t using it and the coasts look pretty jacked up in comparison to the other 85% of the country where folks can live affordably. We won’t be moving our headquarters to Long Island or the Washington DC area. Like Yogi Berra said, “Nobody goes to that restaurant anymore, it’s too crowded!”

Succession

Todd and Ted are doing a great job picking stocks and have been very helpful on the purchase of whole businesses. We want to make sure they never comment in public about what they are doing and don’t give shareholders any chance to judge their track record or rationale for stock selections. The folks running our businesses are also doing well, but we wish Rose Blumkin would come back from the dead. I’ve never met a better business person.

We want to thank all our shareholders for leaving us alone and trekking to the most overwhelming and over-crowded annual meeting in the world. Charlie is having his teeth worked on, because he damaged them last year eating Mrs. See’s peanut brittle. Charlie wants to remind everyone that it is better to own a great company at a reasonable price than run the risk of getting caught in a value trap.

Forever tap dancing to work,

“Warren”

Now that we’ve diluted you with our satire, we want to thank Mr. Buffett for his generosity with his time and teaching. Many of us in the investment industry owe him a great deal.

Warm regards,

William Smead

The information contained in this missive represents Smead Capital Management’s opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Bill Smead, CIO and CEO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.

©2019 Smead Capital Management, Inc. All rights reserved.

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