A Take on the 2007 Berkshire Annual Shareholders' Meeting
(Guest Commentary by Richard Faw – May 13, 2007)
Dear Subscribers and Readers,
I hope everyone has had a good weekend. As I wrote in our latest mid-week commentary, this commentary will feature my close friend and colleague, Richard Faw's quick take on the Berkshire Annual Shareholders' Meeting that was held last week in Omaha. In his discussion, Richard is going to give you the gist of how the meeting was conducted, as well as highlight the important investment issues of today, such as the concept of risk in the academic world and the always-sensitive topic of derivatives. In writing this guest commentary, Richard has found the right balance, as this is probably the only place where you can find a great summary of the entire Berkshire meeting that you can read in less than five minutes. Moreover, just like the format of our last guest commentary, I will end this commentary by commenting on our usual Dow Theory and sentiment indicators chart, as well as a further discussion on why we trimmed our 100% long position in our DJIA Timing System last Tuesday at a DJIA print of 13,299.
First of all I believe a little bit of introduction is in order: Richard Faw works as an investment consultant and his primary focus is in asset-liability modeling for defined benefits pension plans. He is also a Fellow of the Society of Actuaries and CFA Charterholder and can be reached at RichardFaw@comcast.net. Richard is also a great of Warren Buffett and a very dedicated student of the stock market. Richard has written for us once before – please see his May 12, 2005 “Investor or Speculator?” commentary for his last guest commentary. Following is Richard's commentary.
Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice. Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.
Greetings to all readers, and I hope everyone had a great weekend. I want to thank Henry again for providing me the opportunity to post on MarketThoughts.com; this will be my second commentary, and as with my first, this one will depart slightly (although hopefully not too far!) from the theme of the content normally published on the website. My topic for this weekend's commentary will be the Berkshire Hathaway annual meeting that occurred on Saturday, May 5th. I will talk a bit about the event in general and discuss some of the highlights from the actual meeting. This was my second BRK meeting and it was even better than the first. If any of you have an interest in going next year (and hanging out with Henry and me), please don't hesitate to send me an e-mail and I can give you my thoughts on the best way to get set up for the event. I promise it will be well worth your time.
Now, to the commentary...
If any of you attended the meeting, you will know what I mean when I say that it is a spectacle. The festivities actually start on Friday with a cocktail reception at one of the subsidiary companies: the jewelry store, Borsheim's. After the meeting on Saturday, there is a cookout at the Nebraska Furniture Mart, an absolutely ginormous furniture and electronics store. In addition, there are other subsidiaries showcasing their wares during the weekend, most notably NetJets. However, once you get past all of the flair and excitement, you realize that the opportunity to listen to Buffett AND Munger answer shareholder questions for six hours is simply unbeatable. Buffett, who has compounded money at approximately 20% for half of a century and who seems to have a grasp of business, finance and investing better than anyone alive and Munger, who's knowledge extends as easily to opining on the significance of the philosophy of Marcus Aurelius to the fallacy of the application of the Gaussian distribution to the stock market, are together a partnership of brain power and intellect that will likely not be seen for a long time. So, I think it's a great opportunity,... although I am just now catching on to something that about 24,000 people had previously picked up on; oh well, better late than never!
The meeting on Saturday actually starts at 8:30, although the doors open at 7am. A lighter side to the event is the actual moment when the Qwest center is opened to the shareholders; I will confess, at the risk of sounding like a nut, that I got to the Qwest center early enough in the morning to get about 3rd in line, so I had a 'front row seat' for the moment of mayhem when the doors actually open. The second that happens, a sea of people flood in and you witness the greatest heard of nerds you have ever seen, in which yours truly enthusiastically participates, speedwalking (they don't let you run) to get the best seat possible for the event. Once this silliness settles down and the first gaggle of obsessed shareholders captures their seats, the mood settles into anxious anticipation. At 8:30, a one-hour movie is shown, which consists of a montage of new and old video clips of Buffett and Munger, subsidiary commercials and, at least for the past two years, a 20 minute short skit starring Buffett and some big star (this year it was Lebron James). It's certainly entertaining, but the moment of interest arrives when, at 9:30, Buffett and Munger finally take the stage. For the next 6 hours, Buffett and Munger take shareholder questions; the questions are not screened nor are they submitted in advance. Neither of the two have any idea what will be asked, but without exception, every single question, and this included one controversial question this year about, of all things, planned parenthood, is answered with candor and honesty. It is an impressive display. The subject of this year's questions ranged from global warming and how to solve the country's healthcare problems to how to determine a margin of safety and how to judge the character of those with whom you are considering doing business with. There was some great discussion, and there were questions related specifically to BRK the business, but I will summarize here what I thought were a few of the more memorable dialogues related to finance/investing in general. I have taken the liberty of combining certain questions and responses. I may have also peppered a bit of this with Buffett philosophy from other sources such as the shareholder letters, but, on the whole, I have tried to stick to the meeting:
- Someone asked a question about whether or not price volatility measures risk. Buffett responded with an authoritative "no". He said that beta is a nice mathematical measure that simplifies things well, but unfortunately is wrong. He said, which he has said before, that these type of formulas are useful to teachers but useless to investors. For some additional reading on Buffett's thoughts on MPT, check out the 2006 annual letter in which he talks about an old investment friend of his, Walter Schloss.
- Someone asked about how to become a better investor. Both Munger and Buffett responded by saying read everything you can. Amusingly, Buffett said that he had read pretty much every business book in his local library.... by the age of 10. Munger also talked about how a friend of his in the investment business interviews prospective employees stating that you should be able to answer these questions yourself; he asks just two questions: what do you own? and why do you own it? Buffett said that you should be able to sit down and write out the analysis and rationale for making an investment. These make sense, although the simplicity of this seemed worth reproducing here.
- Whitney Tilson asked about their thoughts on the derivatives market. Buffett started this off by saying that derivatives are certainly not inherently evil. (As an aside, BRK followers will note that although Gen Re's derivatives book has been wound down, Buffett has put on a few derivative bets in his investment portfolio). In general, Buffett said that derivatives make a joke of margin requirements (another aside, total return swaps certainly are a candidate for this award!). He invoked the memory of portfolio insurance stating that it was nothing more than a bunch of stop-loss orders, but was intended to protect against risk/loss. Munger dropped in on this one and said that accounting has contributed to the risk. Munger stated that the incentives that managers have to get paid on profits from derivatives will cause them to make questionable marks on the value of the derivatives (calling it the mark-to-model approach). Buffett illustrated the accounting challenges by noting that if BRK and their counterparty were to mark a particular derivative to market, the combined marks would likely not sum to zero, when, in theory, they should.
- A couple questions probed how Buffett might approach handling money today if he had only $1M to invest (instead of $100B) and how often he might examine his positions. He responded by saying that since they currently have more money than ideas (a statement he has made before) that they have to wait. He said that with much smaller sums, he would likely have more ideas than money and would therefore be constantly evaluating which of his current holdings should be replaced by new investments. To paraphrase Buffett and Munger in this question and in another question: opportunity cost is tremendously important. Incidentally, I have seen a few commentators subsequent to this year's meeting say that they believed Buffett, in his response to this questions, was saying that he would not be a buy and hold investor with small amounts of capital. Although I disagree with this, I personally don't have a much of an interest in speculating what Buffett may or may not do with smaller amounts of money. I felt that the take away here was that, in the case where you are evaluating a good investment idea, but you are already invested in businesses with great prospects, buy more of what you already have. I have heard Buffett or Munger articulate this previously as a process of continuously trying to increase your opportunity cost.
There were many more questions this year. For a good transcript of the meeting check out this link: http://boards.fool.com/message.asp?mid=25469398. I do note at least one Munger comment was left out, but overall it looks very comprehensive.
If anyone has any comments, questions or just wants to chat about the meeting or investing in general, I can be reached at RichardFaw@comcast.net
I hope everyone has a great week!
Richard, thanks for your take on the latest Berkshire Annual Shareholders Meeting. I will now continue the rest of our commentary by first expanding our discussion on why we trimmed our 100% long position in our DJIA Timing to a completely neutral position last Tuesday at a DJIA print of 13,299. First of all, following is an update on our three most recent signals in our DJIA Timing System:
1st signal entered: 50% long position on September 7, 2006 at 11,385;
2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;
3rd signal entered: 100% long position SOLD on May 9, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.
As I have discussed in our commentaries and in my posts on our discussion forum over the last week or so, we are now looking for a short-term (over the next few weeks to a couple of months) correction in the U.S. stock market to begin soon. However, given the ample liquidity in our global financial system, and given the fact that equity valuations around the world are still not too stretched, my guess is that we will continue to see higher prices in both the Dow Industrials and the S&P 500 later this year. In the meantime, this author will most probably not go long in our DJIA Timing System again until we see signs of at least a semi or fully oversold condition in the stock market. We will definitely inform our readers once we get there, but for now, I want to show you another reason why we trimmed our 100% long position in our DJIA Timing System last Tuesday.
In our mid-week commentary, I stated that “One of the more reliable “divergence indicators” has historically been the price behavior of the American Exchange Broker/Dealer Index (XBD). As the saying goes, a bull market cannot be sustainable without the participation of the broker dealers, since the profits of broker/dealers are usually dependent on the increase of trading volume, or in other words, a bull market. Therefore – historically, any weakness in a bull market is usually preceded by weakness in the XBD … As mentioned on the above chart, we have again been witnessing a divergence in the XBD – starting with the fact that the XBD has been extremely weak since the correction from late February to mid March. That is, while it only took a month for the Dow Industrials to recover and then to make a new all-time high, it took the XBD nearly twice as long to do so. And while the Dow Industrials had continued to make all-time highs over the last few days, the XBD has actually been exhibiting extreme weakness. While the weakness is not as pronounced as the weakness during May 2006 or February 2007, it is nonetheless a red flag – and thus this author will most probably not initiate a long position in our DJIA Timing System again until we have witnessed some kind of correction both in the XBD or the Dow Industrials or the S&P 500.”
For our sharp-eyed technical analyst readers, however, you may actually notice that the XBD has actually been exhibiting relative weakness since late April 2006, or just slightly over 12 months ago. This relative weakness can be seen by looking at the following relative strength chart of the XBD versus the S&P 500 from July 2001 to the present, courtesy of Decisionpoint.com:
As mentioned on the above chart, the relative strength of the XBD vs. the S&P 500 had actually peaked in late April of last year and has been declining ever since! Note that a lower high was made in mid January of this year – which was to serve as a warning for the February 27th swoon in the stock market. More ominously, the relative strength of the XBD vs. the S&P 500 has failed to surpass its pre February 27th highs, despite a respectable rally of the XBD since early March. Subscribers please pay heed.
Let us now discuss the most recent action in the U.S. stock market via the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from January 2005 to the present (note that we have just changed our starting point, as our old daily chart was getting quite congested):
For the week ending May 11, 2007, the Dow Industrials rose 61.60 points while the Dow Transports declined 5.17 points – the second such non-confirmation over the last four weeks. More ominously, while the Dow Industrials actually made another all-time closing high last Wednesday, the Dow Transports' last all-time high occurred over three weeks ago – on April 25, 2007. In the short-run, this is a signal that the market is now getting weaker (this is consistent with the divergences being seen in the NYSE McClellan Oscillator and in NYSE and NASD new highs vs. new lows). Even should the Dow Transports confirm on the upside by rising to an all-time high tomorrow, we will continue to maintain our completely neutral position in our DJIA Timing System until we see at least a semi-oversold or preferably a fully-oversold condition in the U.S. stock market (more to come on what will constitute a fully-oversold condition in the U.S. stock market in later commentaries).
I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. The latest four-week moving average of these sentiment indicators increased from last week's 23.3% to 24.3% for the week ending May 11, 2007. Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:
As I mentioned in our last weekend commentary, with the latest non-confirmation of the Dow Industrials on the upside by the Dow Transports and with the deterioration of many of our breadth indicators, I am now skeptical of any further rallies in the market – and I will continue to look for a correction as long as our sentiment indicators are not at least moderately oversold – such as the readings that we experienced during April 2005 and October 2005. Again, while U.S. internals suggest that a significant top is most probably at least three to four months away, this author would remain completely neutral in our DJIA Timing System – even should the stock market continue to rally this week.
I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward. Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.
When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls. As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms. This makes the indicator a perfect contrarian indicator for the stock market, and it has had a great track record so far according to the following Wall Street Journal article. Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from October 28, 2002 to the present:
While the 20-day moving average of the ISE Sentiment (at a current reading of 132.9) is still not close to overbought levels, its rally from a reading of 98.5 on March 21st (representing the most oversold reading since a reading of 97.6 at the close on October 30, 2002) is getting “long in the tooth” in the short-run. Again, unless the 20 DMA gets more oversold again, we will continue to remain completely neutral in our DJIA Timing System. In the longer-run, however, the oversold condition of the 50 DMA suggests that the bull market is not over yet, and we will most likely see higher prices in both the Dow Industrials and in the S&P 500 later this year.
Conclusion: I hope you all enjoyed Richard Faw's highlights of the Berkshire Hathaway Annual Shareholders meeting. For those who are die-hard fans or students of either Warren Buffett or Charlie Munger, you will notice that their comments were vintage Berkshire, as exemplified by their comments on the academic definition of risk (beta) and their views on folks who utilize derivatives in their portfolios. As Richard also mentioned, my goal is to attend next year's Berkshire meeting as well – so for those who would like to get together and meet at Omaha in 2008, please do drop us a line.
As for the U.S. stock market, there are now obvious divergences in place. This is made all the more ominous given the current overbought conditions in the stock market and of the capitulation of numerous bears of recent years, including Richard Russell. This “capitulation” can also be witnessed in the latest Yahoo Finance poll, as shown below:
This author is willing to bet that at the bottom of last summer's decline in the Dow Industrials (when the Dow Industrials declined from 11,642.65 on May 10th to 10,706.14 by June 13th), a similar poll at that time would have resulted in significantly more bearish sentiment than what we are currently witnessing. True to human nature, investors typically don't get bullish until AFTER we have witnessed a rise in the stock market, as Warren Buffett fans can attest to. This author does not intend to make that mistake, and we will thus stay completely neutral in our DJIA Timing System – at least until we witness a semi-oversold or preferably a fully-oversold condition in our technical and sentiment indicators. Subscribers please stay tuned.
Henry To, CFA