Patience and Big Swings
"All the misfortunes of men spring from the single cause that they are unable to stay quietly in one room.” - Pascal
“His heart is not listening to his mouth - and, after a while, neither will the market.” - Buffett, 1984 letter to shareholders.
Welcome to new readers this week. Last week we discussed Buffett’s 1983 letter and the importance of synthesizing an investment thesis into a key pressure point(s). Today we move to 1984, with a focus on why the Pareto Principle matters for portfolio construction, along with a discussion about cash allocation strategies.
Like it or not, Pareto rules
Investing is about slugging percentage, not batting average. The reason is because investment returns, like virtually everything in life, obey the Pareto Principle (also called the Matthew effect). The PP captures the fact that a small percentage of inputs are responsible for the majority of any given output. It’s observable in every area of life - the majority of music/books consumed is created by a tiny number of artists; 85% of the world’s wealth is held by 10% of the population; 80% of a company’s revenue is typically generated by 20% of its customers; the majority of cumulative investment returns are delivered by a small number of stocks.
Putting a finer point on it, JP Morgan published a study in 2014 that found just ~7% of publicly-listed stocks delivered essentially all of the stock market’s total return between 1984 and 2014. Roughly 66% of listed companies underperformed the index (Russell 3000, which is a good proxy for the entire stock market), and 40% of all securities provided negative absolute returns.
This creates two logical paths for investors: buy an index and diversify or pick and concentrate on a few probable winners. Either strategy is fine, it’s just important to know which game you’re playing. The pick & concentrate approach requires patience and swinging big when a fat pitch crosses the plate because it’s not worth buying a mediocre company when there’s a two-thirds chance it underperforms the index, and a 40% chance it delivers negative returns. Easier said than done, as Buffett describes below:
It’s been over ten years since it has been as difficult as now to find equity investments that meet both our qualitative standards and our quantitative standards of value versus price. We try to avoid compromise of these standards, although we find doing nothing the most difficult task of all. - 1984 letter to shareholders
Patience is difficult because as humans we are biased toward action, and fear of missing out is a constant, powerful, and real force. Given patience is difficult, most people don’t practice it, and herein lies the opportunity and competitive advantage for investors that master the psychological and temperament component of the game. Patience does not mean being idle. It means preparing and waiting for opportunities in which the odds are so much in your favor that you’d be a fool not to bet big. Buffett did it with Geico in the ‘70-’80s and more recently with Apple in 2016 (Apple accounts for nearly 50% of Berkshire’s current holdings!). These two investments have driven the bulk of Berkshire’s returns.
What to do with retained earnings?
The second theme I found interesting in the ‘84 letter was a discussion about cash allocation. Every company that generates profit has to decide what to do with earnings. Buffett thinks of earnings in two buckets: restricted and unrestricted. Restricted earnings is the portion a business must retain in order to maintain its market position:
Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength.
Unrestricted earnings is the portion leftover after maintenance that a business can either distribute or retain. Earnings can be distributed directly through dividends, or indirectly through share buybacks, which increase shareholders’ existing stake in the business. Retained earnings can be reinvested in the existing business to create future growth, or used to fund acquisitions. In deciding what to do with unrestricted earnings, Buffett and Munger have a simple and logical criterion:
In our opinion, management should choose whichever course makes greater sense for the owners of the business. This principle is not universally accepted. For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders - to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect - backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future - that for every dollar retained by the corporation, at least one dollar of market value will be created for owners.
This dynamic is usually measured by a return on equity (ROE) or return on invested capital (ROIC) figure. When evaluating a company’s capital allocation decisions (how successful have they been/will they be at investing a $1 and generating a $1 or more in market value?), Buffett cautions about taking these measures (ROE, ROIC) at face value because the success of a core business could be masking failures in other areas:
Companies with a core business characterized by extraordinary economics can use small amounts of incremental capital in that business at very high rates of return. But, unless they are experiencing tremendous unit growth, outstanding businesses by definition generate large amounts of excess cash. If a company sinks most of this money in other businesses that earn low returns, the company’s overall return on retained capital may nevertheless appear excellent because of the extraordinary returns being earned by the portion of earnings incrementally invested in the core business. The situation is analogous to a Pro-Am golf event: even if all of the amateurs are hopeless duffers, the team’s best-ball score will be respectable because of the dominating skills of the professional.
Many corporations that consistently show good returns both on equity and on overall incremental capital have, indeed, employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis.
In such cases, shareholders would be far better off if earnings were retained only to expand the high-return business, with the balance paid in dividends or used to repurchase stock...Managers of high-return businesses who consistently employ much of the cash thrown off by those businesses in other ventures with low returns should be held to account for those allocation decisions, regardless of how profitable the overall enterprise is.
I think this is an important and relevant insight for evaluating capital allocation decisions of the biggest tech companies, given they all have 1) wonderful core businesses, 2) they’re generally not experiencing tremendous unit growth (debatable in some cases), and 3) are accumulating enormous amounts of excess cash (in aggregate, Apple, Microsoft, Google, Facebook, and Amazon have roughly $650B in cash and investments on their balance sheets; for perspective, Saudi Arabia, the world’s 20th largest economy, had a total GDP of about $700B in 2020).
A few examples and questions to consider:
Should Facebook be investing tens of billions to build their Reality Labs business?
Should Apple pursue the automotive market?
Should Amazon invest in cloud application software (SaaS solutions) outside of their core infrastructure services (storage, networking, and servers)?
Should Google be pursuing cloud computing (GCP) and autonomous driving (Waymo)?
Should Netflix pursue gaming?
The incredible quality of the above companies’ core businesses creates a very high hurdle for justifying investing retained earnings in other areas. In addition, given the already-immense size of their businesses, they have to pursue large opportunities to move the needle, which likely increases the riskiness of the investment.1
I think it’s a valid and helpful question to ask, at which point are these companies so big that the best thing for them to do would be buybacks and distribute dividends to shareholders?
In addition to the size of the bet, the more a company expands, the more likely it pursues growth opportunities that are outside of its core competency as a business.
Another great article. Thanks. Just this morning Tim Cook addresses this topic head on. When asked about future products. He said (paraphrasing) that they would only invest in new products that can improve people's lives. We may recall Steve Job's famous kitchen table metaphors (no longer true) that all their products could fit on a kitchen table. Apple spends very little on acquisitions, other than IP or talent based acquisitions.
When I evaluate a company for investment, the first question: Is this a product company or a portfolio company? Portfolio is the wrong answer. Good product companies think about the long-term benefits that current investments hold for the users of their products and services. Getting that right ensures market share and good margins.