A Good Model

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By Dr. Phil Holmes

How good are you at recognising genius? If you have a genius standing in front of you, can you see it and feel it, or is the person so strange that she/he is just written off as being odd? How our brains work makes us human and there is no doubt that genius brains work differently; they just don’t work like ours!

Arguably, one of the greatest and best known geniuses in human history was Albert Einstein. Out of the blue, as a young man in his twenties, he explained how the universe works and turned science, as we knew it then, on its head. There have been some like him since in various fields and there will be more to come; it is a product of human intelligence development and the scientific method. It is what separates humans from all other life forms on earth. Another genius, Charles Darwin, explained how all this happens. It has been a slowly evolving and continuing process over countless millions of years; not a blinding flash 6,000 years ago.

And so, back to genius, but let’s narrow the focus to business; consider Warren Buffett.

For those who are unaware, he is a product of Omaha, Nebraska, a mid-west USA town, far from the stratosphere of New York’s Wall Street. He stills lives there modestly and goes to his office every day in a clapped-out old car that the wreckers should have. He is currently worth USD 84B, with his 18% share in the company that he bought (Berkshire Hathaway). He gained control of the company, a textile producer, in 1965, averaging a purchase price of USD 14.86 per share. Recently, those same shares were trading at just over USD 300,000, representing an annual compounding return over the period of 21%. Today, Berkshire Hathaway is a vast global conglomerate owning everything from railways through furniture retailers to chocolate makers. The textile manufacturing was ditched early on. In essence, the purchase of Berkshire Hathaway was just a means by which Buffett could own and control a listed company that would allow him to grow a behemoth and have full control over the allocation of the river of cash that it produced.

Early on, he was very averse to investing in anything even remotely connected to agriculture, but in recent years he has mellowed a little as it dawned on him that no more farming land was being produced, globally. Today, he is more interested in the property ownership aspect of it, rather than the performance of the underlying businesses. Obviously this is unsustainable if the increasing operating returns from the underlying businesses do not match the capital returns of the property assets, but you can be sure that he has done his homework thoroughly on this, before investing.

He is the third richest person in the world, even with his meagre 18% share of Berkshire Hathaway, if that matters. It obviously doesn’t matter to him as he in the process of giving it all away to charity, along with his friend Bill Gates (Microsoft). Many books have been written about Buffett for you to pursue if it interests you. Above all else he is humble and self-deprecating. The best starting point is to go to the Berkshire Hathaway website and read the ‘Letters to Shareholders’ from Buffett. Most of them are there since 1965 and if you take the time to read them, you will uncover nuggets of business management gold.

The main focus here is on his business model and how it can apply to Australian beef production businesses, as loose as this link may appear to be at face value. This is the neat thing about genius. Once you understand what a genius is on about, it all looks so simple, often making you wonder why you didn’t think of it yourself. As well, you do not have to be a genius to use and benefit from the thinking. The following summarises what we think are the essentials:

  • The fundamental process involved with the Buffett genius is the allocation of capital (managing the mint). It must be rational and rigorous with no room for whim or sloppy thinking. Mistakes will inevitably be made, but all the effort should be directed to minimising them and maximising the potential for good capital allocation decisions. It requires incisive thinking, discipline and patience. Good capital allocation decisions result in more capital being available over time; a compounding process. Albert Einstein, no less, described financial compounding as the most powerful force that he had ever witnessed. A big call from him!
  • Never pay more for an income earning asset than its intrinsic economic value. Never! To hold true to this requires extraordinary discipline. You have to be able to sit on the sidelines and watch the Lemming race, often for years at a time, waiting for the right opportunity, as madness continues in front of you. As one of history’s most famous economists, John Maynard Keynes, observed, ‘Markets can remain irrational longer than you can remain solvent’. Buffett remains a big fan of Keynes.
  • Never lose money. Never, ever! At first this seems trite, but it has a sound financial basis. It took us some time to understand the wisdom here because it is not apparent until you do the sums. Let’s say you start with $100 and in the first year it shrinks to $50, a 50% loss. To get back to start next year, you need a 100% gain. It is much, much harder to gain 100%, than lose 50%. As well, it is profoundly misleading. In simple arithmetic terms, you can be deluded into thinking that your two-year average return is 25% ((-50+100)/2). In fact, it is a big fat zero! Believe it or not, even some experienced financial analysts/fund managers do not understand the principle at play here and continue to delude investors as a result. No wonder there is flood of individuals moving into self-managed superannuation and a Royal Commission into the shoddiness of the current system. Admittedly, there is a plethora of other issues for the Royal Commission to consider.
  • Always buy quality assets at a fair price, not rubbish assets, cheaply. The latter may seem like a bargain at the time, but the future cashflows and inevitable headwinds will almost always disappoint. Excellence in due diligence is therefore critical. Buffett used to buy dubious assets at a bargain basement price and did very well out of it for a time, before scale issues dealing with minnow companies overtook his thinking. His (almost) lifetime business partner, Charlie Munger then moved in and convinced Buffett to ‘buy quality assets at a fair price’. This was the point at which the Berkshire Hathaway performance really took off.
  • Ensure that every asset is a stand-alone profit centre. Not one of the myriad of the companies owned by Berkshire Hathaway is dependent on any other for its performance. The minute you choose to integrate business activity, is the point at which overall business performance is potentially compromised. Yes, that statement is true for beef production too. Want to breed here and finish there? Think about it long and hard and do your sums very carefully because they do not stack up to financial scrutiny very often. Stand-alone profit centres should always be the priority.
  • Employ really good people and let them do their thing. Buffett has no idea how to run a railroad, sell furniture, or produce a box of chocolates. He just lets the people who do that well, do it for him, and concentrates on capital allocation, his strength. His head office is tiny, occupied by a skeleton staff. His only advice to the managers of all the Berkshire Hathaway companies is ‘Ring me if you need more capital for a good business idea, otherwise just do your thing and don’t bother me. If your performance lags, I will ring you’. Set up a centralised Head Office, trying to micro-manage everything at a distance, and watch the performance of the whole show start to slide.
  • Ignore forecasts of any kind. Ignore industry hype and noise. Ignore spruikers. Ignore what the market is doing. Ignore pub talk (more calves are born in the pub than any paddock in the country). Ignore everything but objective evidence and your own independent thinking; do your job well. Concentrate on the fundamentals of your business.

There are only two chances that the Buffett business model will allow you to accumulate his wealth in your ownership/management tenure in Australian beef production. However, we have a lot of evidence-based confidence that judicious application of the model principles will produce a better long-term result for you, than just ignoring them. Perhaps make up the gap by buying Berkshire Hathaway shares (the Class B shares are on a lot lower multiple and are within reach of most).

In the 2017 Australian Beef Report, we have addressed the above issues in some detail, believing that the Buffett genius is a proven model. If it interests you, The Australian Beef Report (www.bushagri.com.au/abr) may be worth a read as an early step on the path to a better outcome.

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