Has Warren Buffett Lost His Touch?

Steve Pomeranz: Whitney Tilson is the founder of Kase Learning, an educational platform offering programs for people interested in becoming better investors and launching and building successful investment management businesses. Whitney has also co-authored two well-regarded books about investing and ran his own hedge fund and produces a newsletter that is always fascinating to read. Now I’ve first noticed Whitney at the Berkshire Annual Meeting in Omaha, where year after year, he had this uncanny ability to get to the microphone to ask Warren and Charlie Munger a question. So I contacted him and found out a lot about him. And he’s been on the show a few times. Welcome to the show, Whitney.

Whitney Tilson: Thanks for having me, Steve, good to be back.

Steve Pomeranz: My first questions for you has to do with the business results and subsequent comments made by Warren Buffett after the release of his most recent annual report. And my question is simply, should investors continue to bet on Warren Buffett? But before you answer, let me go through a short list that I made and we’ll start with Heinz. Now if you follow Warren Buffett at all, you know that Heinz, he admitted, was a big misstep. Heinz took, oh, a $15 billion write-down on their core brands of Kraft and Oscar Mayer. There’s an SEC investigation into their accounting practices, which may require a restating of several years worth of earnings that cut their dividend 36% and their cash flow guidance projects a 10% decline for the upcoming year.

So, Whitney, what happened with Heinz?

Whitney Tilson: Well, it’s a complicated story, and it’s important to note here, by the way, that this has not been a bad investment for Berkshire Hathaway. It was a spectacular investment, and now that the stock has been hammered, it’s turned into sort of an investment where Buffett doubled his money instead of made five or six times his money. So this is an investment where Buffett backed three Brazilian guys with a group called 3G that acquired Kraft, and then Heinz, and combined them into this Kraft Heinz company today. And they are big cost cutters and their cost cutting appears to have been overdone. They cut out a lot of fat, and they’re very good at that.

But it appears like they also cut into muscle and bone, and so that combined with general struggles across the consumer packaged goods industry has really led Kraft Heinz results to suffer. And the stock, which got way ahead of itself, has really come back in a lot. So I don’t think Buffett considers the overall investment a mistake or at least the initial investment, it was done as a two-step investment, and he acknowledges they probably overpaid for the second piece of it. But I’m sure Buffett’s not real happy about it right now. But keep in mind that this Berkshire has almost a $500 billion market cap, and this represents only a few percent of Berkshire’s value.

Steve Pomeranz: Yeah, one investment does not mean that he’s lost his touch. But when you look at further comments from him, and he spoke, Becky Quick from CNBC interviewed him, and he spoke about his top managers Todd Coombs, and Ted Wexler and Buffett himself, not outperforming the S&P 500. Coupled with frequent statements made by Buffett, that index fund investing is superior seems to lead credence to this idea that beating the S&P is extremely difficult. And if Buffett and his two expert managers are having trouble doing it, why should we bet on Berkshire Hathaway?

Whitney Tilson: Yeah, well, look, by the way, I agree with his general advice, that most people will be very well served by just sticking to a super low-fee index fund, like the Vanguard S&P 500 Fund, for example. That’s in fact, Buffett has said that when he [INAUDIBLE] away, he owns money outside of Berkshire, he has assets outside of his Berkshire stock, but that 80% will be indexed to the S&P and 20% will be in cash upon his demise. So the question is why Berkshire, I think, will outperform the S&P?

And I think it’s because it’s probably 20% undervalued today. It’s an incredible business run by the world’s greatest investor. But you should have realistic expectations. Berkshire’s not a get-rich stock, it’s a stay-rich stock. And so I think it’s likely to outperform the S&P by a few percentage points a year. So I’ve got my parents, for example, who are in their late 70s, are mostly in index funds. But they own some Berkshire as well because I think there’s a decent chance, I’d say there’s a 75% chance, that over the next five or ten years, Berkshire will outperform the S&P 500.

Steve Pomeranz: Well, you mentioned that it’s selling at a 20% discount to its intrinsic value or some valuation similar to that. So that in and of itself, even if the portfolio of businesses produces a return similar to the S&P 500, if at any time that gap closes, that 20% discount closes, there could be some possibility for outperformance?

Whitney Tilson: Well, I think you win in two ways with Berkshire. Berkshire’s intrinsic value is, which is Berkshire is a collection of 75 operating businesses and then it’s a stock and bond, an investment portfolio. And I think both pieces of Berkshire, but particularly, the operating businesses, are doing really very well. And so I think intrinsic value is growing in the high single digits. And by the way, and so if the stock merely tracks the growth of Berkshire’s intrinsic value, then, I think you’ll do better than the S&P 500, which I expect would compound, given that it’s pretty close to all-time highs today.

I think, realistically, in a US economy, growing at low single-digit GDP growth, you might expect mid-single digit growth in the S&P 500 over the next five to ten years. I think you should have very realistic expectations there, so if Berkshire’s intrinsic value is compounding in the high single digits, that’s going to beat the S&P 500, assuming the stock tracks that. And then I think you win in a second way if the gap to Berkshire’s intrinsic value closes somewhat. I peg intrinsic value at about $363,000 per A share. The stock is at 305 today, so that’s a 16% discount to intrinsic value today.

Steve Pomeranz: Of course, as a warning to investors, discounts can stay around for very, very long periods of time. Just because something is selling below intrinsic-

Whitney Tilson: And they could widen.

Steve Pomeranz: Pardon me, what?

Whitney Tilson: And they could widen.

Steve Pomeranz: And they can widen as well [LAUGH], as we all know. So I was wondering if part of the problem was the fact that prices have been for stocks that Warren wants to buy, have been a little high for the last number of years. And so he has not made any really big purchases. And so there’s a huge cash build up, 112 billion at last counting, 34.6% of the value of the portfolio is in cash. I was wondering whether this was a typical late cycle effect of Buffett’s strategy, in that he won’t overpay for stocks or just be in stocks for the sake of being in stocks. And during the late cycle or long bull markets, they’ll tend to underperform near the end. What do you think about that idea?

Whitney Tilson: Yeah, I think there’s a lot of truth to that. Buffett has been very upfront that it’s around the world, but he focused, it’s not 100% but he’s mostly looking in the United States. Though he’s really making an effort to try and fly overseas as well, but it’s primarily US focused. And with the markets, I mean, he’s looking to buy two things. Keep in mind, he’s got well over $100 billion of excess cash he’s looking to put to work, but it’s a high-class problem. He has well over $1 billion a month pouring into Omaha from the profits of the operating businesses. So it’s a high-class problem, but it’s a problem that’s getting worse. The cash keeps piling up, and he has not done any major acquisitions.

He’s looking to do two things: buy stocks, publicly traded securities, and also buy private companies. Like the last big deal was Precision Castparts three years ago. But he also bought, years ago, Burlington Northern was one of the biggest deals ever. So he really prefers buying private businesses and owning them outright. But the problem is in both areas where he can invest, the stock market, and buying private companies, the prices are high. There’s a lot of competition, and he’s not going to overpay. And I respect that discipline, but it does mean that cash does act as an anchor on Berkshire. So I do think Berkshire is more likely to outperform the S&P in a flat to down market than in a strong bull market. But keep in mind, over the last ten years, we just a couple days ago passed the ten-year anniversary of the bottom of the bear market.

Steve Pomeranz: Yeah.

Whitney Tilson: In March of ’09, that over that time period, the S&P 500 has exactly quadrupled with dividends reinvested. And Berkshire Hathaway has done exactly the same, it’s also quadrupled. So you might say, well, why do you like the stock if it hasn’t beaten the market over a ten-year period? And the answer is, is that the fact that a very cash-rich conservatively financed company, much, much safer than the average company, is keeping up in one of the strongest bull markets in history. I think is a real testament to what a great stock it is, and, but it’s a sleep-well-at-night stock. I think where it would really shine is in a down market.

Steve Pomeranz: We’re going to stop right here for a moment. We were having some technical difficulties there, so we called Whitney back and we are now on his cell phone. So you may hear a little bit different quality, but it’s the same discussion, same guy. Same two guys talking and trying to figure things out. My guest is Whitney Tilson, he’s the founder of Kase Learning. He’s owned and operated his own hedge funds and he’s very, very familiar with Berkshire Hathaway. And talking about Berkshire Hathaway, Whitney, how did you get to this intrinsic value number? It’s such a huge company and a lot of those companies are private.

Whitney Tilson: Yes, there’s a complex answer, but I’m going to give you a very simple answer because I don’t think complexity really helps here. The way you value any company is you look at the cash or the cash equivalence that you would be buying if you bought the company. And then you put a multiple on the earnings of the business, and Berkshire lends itself beautifully.

It has a great big portfolio of cash, bonds, and stocks that you just value at their current market value. And that gets you to about $195,000 per a share, and then the company generates $14,000 a share of operating earnings. I put a 12 multiple on that, and that gets you, when you combine those two, it gets you to $363,000, about $364,000 per a share. And the stock today’s trading at around 304, 305, so it’s about a 16, 17% discount to intrinsic value the way we calculate it. But keep in mind, intrinsic value is a range.

Steve Pomeranz: Yeah.

Whitney Tilson: Reasonable people could come up with somewhat different numbers but Berkshire actually isn’t that hard to value.

Steve Pomeranz: It’s interesting because this idea of valuation is one of the most important factors in investing. And so many things are difficult to value. For example, when you talk about gold, for example, gold doesn’t throw off any cash. It actually costs money to store and hold, and yet it has some kind of a current value.

But if someone said, what is the intrinsic value of something like gold or something like Bitcoin, I think someone would be hard pressed to say, it’s worth X in reality. When you’re dealing with companies that throw off cash flow, you can kind of figure out rates of return and intrinsic value will follow from that. Would you agree with that assessment?

Whitney Tilson: Yes, I would put Bitcoin at one extreme. It is impossible to value, gold is somewhere out there in that part of the spectrum, though gold does have some industrial uses, et cetera. And then at the other extreme would be something that’s very quite straightforward, like Berkshire Hathaway. Where you can add up the cash, the bonds, the stocks and put a multiple on the earnings of the operating businesses. And you can come up with a pretty tight range of intrinsic value.

Steve Pomeranz: So I want to get back to this idea that we’ve just passed the tenth anniversary of the day that stocks bottomed during the Great Recession.

Now for those of us, you and I, and others who lived through that as an investor, you write that it’s hard to convey the degree of total panic at the time. Bring us back to March of ’09, and the quarter before then and what really we were experiencing. And how difficult it was to even think that the market and the economy was going to continue on.

Whitney Tilson: Yeah, it was a period of just incredible panic, it was the biggest stock market decline since the Great Depression. And the financial system had effectively frozen up, and there were so many causes and so many pieces of this, but let me see if I can sort of summarize it in a way your listeners will understand. Any country, any modern economy’s lifeblood is its financial system, its banking system. And keep in mind that debt markets are much larger than equity markets or stock markets, right? But debt investors are very conservative and they do not expect to ever take any loss of principal, right?

Steve Pomeranz: Right.

Whitney Tilson: And what happened was lenders went crazy, and the world’s largest debt market is the US mortgage market. But the craziness was not limited there, it infected commercial mortgages and all types of debt and then to make matters worse, people made a lot of side bets through exotic derivatives like credit defaults swap where, you know, investors could see that the major financial institution had bigger exposures and big losses and it made big mistakes.

But what really freaked people out is every day it seemed, there were new reports of off-balance sheet liabilities and losses that investors didn’t know about and that created real fear and panic. And so basically, banks no longer trusted each other and the entire financial system, for a matter of days anyway, particularly when Lehman went bankrupt, almost ground to a halt. And it took the US government, the full faith and credit of the US government, the world’s largest economy, it counts for 23% of the world’s GDP, basically had to come in and backstop, not just the US financial system, but the global financial system. Cause it wasn’t just the US banks that were seizing up, so it was a time of real panic. And I think Buffett said, it was as if the patient was having a heart attack and was in cardiac arrest.

And thank goodness, the US government came in and basically bailed everybody out which left an unpleasant taste in a lot of people’s mouths, but I assure you if your credit card stopped working and you went to the bank, to the ATM to withdraw cash from your account, and it said you can’t have your cash, that’s what we were literally facing. We were within days of that kind of outcome.

Steve Pomeranz: Yeah, I remember that, also there’s this old saying that if you see a line forming around the bank, join it. [LAUGH]

Whitney Tilson: Yeah, yeah.

Steve Pomeranz: So that aside, investing during that period of time, you mentioned one particular stock that was selling for around $8 a share, and it was selling at a big discount to your calculation as to what it was worth. But just because it was cheap, didn’t mean it couldn’t go cheaper, and it ended up going to $2 a share. Living through that, and the self-doubt that comes with this idea that you can’t absolutely be sure that you’re making the right decision, what did that feel like then?

Whitney Tilson: Yeah, I could see that stocks were cheap, and I just had confidence that the government would do what was necessary to prevent a total collapse. And so I was buying stocks as they fell, but every day, everything I bought the previous day, opened up cheaper the next day. And stocks that I bought that were 50 cent dollars became 40 cent dollar and then 30 cent and then 20. So that particular stock you mentioned, a specialty chemical company called Huntsman was a good business.

But it had debt, and anything that had debt at the time, normally when debt comes due companies could just roll it, but not when financial markets have seized up. So the fear was that Huntsman would be forced into bankruptcy, and the shareholders would be wiped out. And so a company, a stock that was easily worth $15, there had been a buyout offer at $26 a year earlier but was trading at 8. And so I thought I was buying a 50 cent dollar, and I was, but that didn’t prevent the stock a few months later from going as low as $2 a share, and then it went to 20 in less than two years.

So I was right about the intrinsic value, but psychologically, it was brutal to lose 75% of my money in just a few months.

Steve Pomeranz: But then the market turned. And you write, in your wildest dreams could you have imagined that ten years ago, this sentiment would change so quickly that investors would be willing to put their money at risk, and see the S&P 500 quadruple from that low. But the story’s not over there because you write in your newsletter that there was some serious mistakes that you made on the way up.

And I’d like to address those as well, just to kind of give people an idea that this idea of investing is simple, but it’s not easy. So, let’s talk about three mistakes that you write about. You turned cautious way too soon. You trimmed then exited positions that you should have held, and then you write most painfully, Netflix. Talk about that a little bit.

Whitney Tilson: Sure, basically, I played the downturn really quite well. I didn’t nail the bottom to the exact day, but I bought that stock that went from eight to six to four to two, I bought all the way down and made a fortune when it went to 20. So I predicted the downturn reasonably well. I started buying down near the bottom, made a ton of money in the first year or two coming out of the downturn.

But then I turned cautious. And that was a big mistake. I did not foresee a ten-year bull market, I did not foresee investors who had just been in absolute panic within a year or two becoming complacent and embracing risk. So I played defense. I positioned my fund for a storm that never came. And so that meant that I was holding a lot of cash, it meant that I was shorting stocks in addition to owning stocks, I was hoping they would go up. I shorted companies that I thought where the stocks would go down and, of course, pretty much every stock has been going up in the last decade.

Steve Pomeranz: Right.

Whitney Tilson: So that was costly. And then even when I had some of the greatest stocks of the decade, like Netflix, which went up 50 times from its lows, I owned Netflix. And not only did I own it, I pitched it at a conference and on national television the day that it hit its low, and I still made seven times my money, that was great. But making seven times your money on a stock that ends up going up 50 times, isn’t so great.

So the lessons here are, generally, I think most investors would be well served to not, you know, read all the hysterical headlines every day in the newspapers and the internet people predicting market calamities or whatever. Just stick to index funds, save—every year if you spend less than you earn, therefore, you are saving—and take those savings, the long-term money that you don’t need any time in the next year or two, and just consistently put that money into index funds and just ignore the market and ignore the prognosticators.

I tried to be too smart; I tried to have an opinion on the market when really what I’m good at is just picking stocks like Berkshire Hathaway, and like Netflix. Had I just stuck to my knitting and not tried to have some big market opinion I would’ve done a lot better.

Steve Pomeranz: Danger in being too smart, and not staying humble in light of what’s so hard to know, the actual future. My guest, Whitney Tilson, founder of Kase Learning, which is an educational platform that he’s offering now for people who are interested in becoming better investors and launching their own investment management businesses. Co-author of two books, very well-regarded in the investment industry. Whitney, thank you so much for taking the time to join us today.

Whitney Tilson: My pleasure, thanks for having me.

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