Just Own Berkshire?

A friend asks:

Is the portfolio you own with shares of Berkshire Hathaway diversified enough to be your entire equity portfolio?

Here’s my response, with a bit of added color versus my original reply. It’s helpful to have Berkshire’s top 13F holdings (included below) for reference:

180930_BRK_13F
Source: Berkshire 13F via WhaleWisdom.com

Do I think you could buy today’s Berkshire 13F portfolio and hold it forever as a well-diversified portfolio? No. There’s no such thing as a permanent stock portfolio. Capital markets are far too dynamic for that.

What you’re really buying (and thus have to underwrite) with a share of Berkshire are Warren and Charlie’s capital allocation skills. This is an extremely concentrated portfolio. Not necessarily a bad thing for skilled investment managers like Warren and Charlie. But just a handful of stocks and their idiosyncratic characteristics are going to drive portfolio performance.

Do I believe you could plausibly own Berkshire and only Berkshire as a kind of closed-end fund/ETF managed by Warren and Charlie? Yes, I do. The obvious issue you run into here is that sooner or later Warren and Charlie are going to shuffle off this mortal coil. I suspect it’ll be much tougher for investors to maintain the same level of conviction in their successors.

Would I do it myself? No. It’s an awful lot of single manager risk to take, to just own Berkshire. Even if Warren and Charlie were immortal, it would be a lot of single manager risk to take. However, I could definitely see using Berkshire alongside just a couple other highly concentrated managers, if you’re the kind of investor who doesn’t mind high tracking error and is concerned more with the risk of permanent capital impairment than volatility.

Could you potentially just use Berkshire in place of an allocation to large cap US stocks? Yes, I definitely think you could.

The answer to this question really hinges on your definition of risk, and issues of path dependency in investment performance. In my view, the starting point for any asset allocation should be the global market capitalization weighted portfolio. Deviations from the global market capitalization weighted portfolio should be made thoughtfully, after careful deliberation. Whenever you deviate from the global market capitalization weighted portfolio, you are implicitly saying you’re smarter than the aggregated insights of every other market participant.

Sorry to say, but you’re probably not that smart. I’m probably not that smart, either.

To concentrate an investment portfolio in a single share of Berkshire implies you have a massively differentiated view of where value will accrue in the global equity markets, and that you’re extremely confident in that view. In hindsight, it seems obvious Berkshire would be a great bet. But in financial markets, literally everything seems obvious in hindsight.

Does this mean a concentrated bet on Berkshire wouldn’t work out?

Absolutely not. It just means we need to carefully consider whether a highly concentrated bet on Berkshire makes sense in light of its potential performance across a broad range of possible futures.

Personally, I’m not confident enough in my ex ante stock and manager selection abilities to bet the farm on a single pick like that.

And I think that’s true for most of us.

Ode To Liquidity

When it comes to risk management there is one consideration that towers over all the others. That is liquidity.

The word “liquidity” can mean different things in different contexts. Sometimes it literally means “cash.” Other times it refers to your ability to quickly convert the full value of another asset (like a stock or a mutual fund share) into cash. This post will reference liquidity in both contexts.

Liquidity (“cash”) is the lifeblood of our financial lives. It is the medium through which we move consumption forwards and backwards in time. It is the bridge that links spending, saving and investment.

You don’t fully appreciate the importance of liquidity until you need it and don’t have it.

Poor people understand this intuitively. For a poor person life is a never-ending liquidity crisis. It is the global financial crisis on repeat. There’s a reason the foundation for all financial planning is the net cash emergency fund. The net cash emergency fund is your liquidity buffer. It’s loss-absorbing capital. It’s what keeps you from getting caught in the vicious cycle of dependency on short-term, unsecured, high cost debt like credit cards and payday loans.

Funnily enough, there are plenty of rich people who live life on the edge of a liquidity crisis. Some of these people have a large amount of their net worth tied up in real estate or private business ventures. You can have a lot of paper wealth but still very little liquidity.

When the shit hits the fan, your paper net worth is irrelevant. If you don’t have enough cash on hand to meet your financial obligations, you are toast. This is the story of every banking crisis in the history of finance.

Sure, you can sell the illiquid things you own to raise cash. But that takes time. And the less time you have to sell the worse your negotiating position gets.

There is nothing a shrewd buyer delights in more than finding a forced seller who’s running out of time. This is the essence of distress investing. Distressed investors are often able to buy good assets for fractions of their value because the sellers are desperate for liquidity.

Does this mean you should never own illiquid things?

No!

It means you should never assume you will be able to sell an illiquid thing at a favorable price at a place and time of your choosing.

As an individual, how do you know if it’s okay to own an illiquid thing?

If you can write it down to zero the moment you buy it, and it will not impact your ability to make good on your day-to-day obligations, it is okay to own the illiquid thing from a liquidity standpoint. The thing may still turn out to be a terrible investment, but that’s a separate issue.

These days there are lots of things being marketed to regular folks that are illiquid things disguised as liquid things. These are things like interval funds–the mutual fund world’s answer to private equity. These are also things like non-traded REITs with redemption programs that allow you to withdraw, say, a couple percent of your investment every quarter.

Perhaps your financial advisor has pitched one of these things to you.

Read the fine print!

The underlying assets in these funds are illiquid, and the fine print always allows the investment manager to suspend your redemption rights. Third Avenue Focused Credit investors thought they had daily liquidity, like in any other mutual fund.

Ask them how that worked out.

Pity The Fools

Pity the babies of 1987 and 1990, then, who left school or university around the time that Lehman Brothers collapsed in 2008. Sending around a CV in the middle of the greatest financial crisis since their grandparents were born cannot have been a whole lot of fun.

That’s Tim Harford writing in the FT. As one of those babies of 1987, I can assure you it was indeed hell to send out resumes in the middle of the greatest financial crisis since my grandparents were born.

There are a lot of good articles out there about how your lived experience in markets and the world shapes your behavior. Here’s an especially good one from Morgan Housel.

So how did the financial crisis shape me?

Mainly, it made me paranoid.

It taught me talk is cheap.

It taught me no one’s entitled to a happy ending.

It taught me that money talks and bullshit walks.

It taught me you can do business with people who wield power and influence, you can respect people who wield power and influence, but you should never trust people who wield power and influence.

Most of all it taught me that at the end of the day, the only things you should count on are your skills and your character.

Don’t get me wrong. People can be wonderful. I’ve benefited from the support of many individuals who took an interest in my career development over the years. I will always and ever be grateful for the opportunities they offered me. Particularly in the early days, when I was a poorly-credentialed career changer with the wrong resume.

But here’s the thing about people. You can’t control their behavior any more than you can control the macroeconomy.

It’s Just Business

“Your father did business with Hyman Roth, your father respected Hyman Roth, but your father never trusted Hyman Roth.” – Frank Pentangeli, The Godfather, Part II

Frank Pentangeli is one of my favorite characters from The Godfather movies. He’s a lovable, old-fashioned gangster struggling to eke out a living in a brutal and cynical world. Frank’s fatal flaw is that he’s not smart enough to see all the angles. He never fully grasps how completely he’s at the mercy of forces much larger and more powerful than himself. He clings to a code of honor that seems increasingly outmoded as the plot evolves.

And so, it’s fitting that when Pentangeli finally goes out near the end of Part II, it’s not because someone whacks him. It’s because Tom Hagan convinces him the only way to salvage his honor and dignity is to off himself. The scene is one of the best in all three movies.

In Epsilon Theory speak, Frankie Five Angels is a lousy player of the metagame. (h/t to Epsilon Theory for inspiring this post, btw)

godfatherii_tom_frank

Despite Frank’s obvious flaws, his acute sense of personal honor was useful when it came to judging the character of his business partners and counterparties. His most famous line (quoted above) is a testament to the fact you can always choose to do business with someone at arm’s length. Trust is not a prerequisite for a mutually beneficial business relationship.

So it is with the sell-side.

We do business with the sell-side. We respect the sell-side. But we should never, ever, under any circumstance trust the sell-side.

I was moved to reflect on this after another one of those “market outlook” meetings where a “portfolio specialist” (a salesman with his CFA designation) from a big asset manager comes and talks to you about how the next recession is at least a couple years away* and sure there some risks but nonetheless the fundamentals are sound. Oh and by the way have you looked at leveraged loan funds lately?

Sure, leveraged loan covenants suck, and the space is red hot, and investors will get burned eventually. But there’s still a couple years left in the trade.

Sure, high yield looks like a crap deal on a relative basis, but on an absolute basis there’s still a supportive bid for yield from foreign buyers.

Sure, this stock trades rich, but our analysts can see a path higher from here.

How many times have you heard this stuff? Or stuff that rhymes with this?

Our relationship with the sell-side should always and everywhere be a transactional relationship. But the goal of every great salesman is to turn a transactional relationship into a personal relationship. Personal relationships bring with them all kinds of social conventions and obligations. Unless you’re a complete sociopath, it’s nigh on impossible to behave in a transactional manner once a business relationship turns personal.

That doesn’t mean you can’t go to lunch with the sell-side.

It doesn’t mean you can’t use research from the sell-side.

It means you should never, ever under any circumstance allow yourself to believe the helpful guy or gal from the sell-side you have lunch with once a quarter is truly on your side of the table, always and everywhere with your best interests in mind.

If you do this, and you choose to trust these people instead of merely transacting business with them, you will eventually discover that they do not, in fact, sit on the same side of the table as you. They do not, in fact, suffer like you when the bill of goods they’ve sold you blows up.

And it’ll cost you.

*The next recession is always at least a couple years away.