Pension Asset Management in the Scale of Business Priorities
Of course, the desirability of even considering something non-conventional (not to be equated with more risk; the exclusive benefit provision of ERISA requires fiduciaries to discharge their duties "solely in the interests of the participants and beneficiaries") relates to the relative impact pension results can have on overall earnings. One of my friends always reminds me: "If a thing's not worth doing at all, it's not worth doing well." If our pension assets were $1 million and likely to grow only a few hundred thousand dollars a year, it would be ridiculous to think of any activity that might incur even unwarranted criticism, let alone litigation. On the other hand, if we had U. S. Steel's pension situation, we might want to make a truly top priority project out of pension asset management (as they have), even if we might slightly increase personal risks to directors by so doing.
We fall in between although, if you look through to the plans to which we contribute but don't manage (Guild, mechanical, etc.)[***] we are moving more in the direction of U. S. Steel. It is likely that within ten years we will have $40 million in our direct pension "division" and further substantial sums in other plans presently on an indirect basis. Earnings of businesses purchased through this "division" should run at least $5 million per year.
[***] In prior years it was felt that by limiting contributions to union plans to so much per shift, or per hour, management was relieved of responsibility for any specific level of benefits, as well as pension fund administration. The shield of this "hands off" position is eroding and we should recognize that we may well have responsibility at some future date for benefits promised under these plans, which we originally thought involved only defined contributions. With this in prospect, we may wish to gain at least partial command over fund investments in this area.
Summing up:
(1) If the economic world turns out to be one of sustained double-digit inflation - probably still unlikely but not unthinkable - among the carnage will be private pension plans. The investment process can do little to modify that disaster. Hope lies mainly in the care with which past promises have been made, and the ownership of a business whose economic characteristics allow pass-through pricing which includes a large part of past labor costs, as well as full current costs.
(2) In a more orderly world, the care with which promises have been worded remains important, but on a scale that diminishes as inflation moderates. Conventional approaches to money management should not be expected to produce above average results. But average will be perfectly acceptable at low inflation rates.
(3) A mildly non-conventional investment approach, emphasizing a business approach to security selection, gives some opportunity for long-term results slightly above average without corresponding increase in investment risk.
Q: What daily habits would you recommend practicing?
Munger: I have never succeeded very much in anything in which I was not very interested. If you can't somehow find yourself very interested in something, I don't think you'll succeed very much, even if you're fairly smart. I think that having this deep interest in something is part of the game. If your only interest is Chinese calligraphy I think that's what you're going to have to do. I don't see how you can succeed in astrophysics if you're only interested in calligraphy.
Q: If you were to start another Berkshire, in what form or structure would establish this. A partnership or a C-corp?
Munger: That's a very intelligent question. Berkshire happened by accident. Having a lot of marketable securities inside a corporation with 35% taxes on every gain: No investment vehicle chooses that. It's insane. We just stumbled into it. Now we made it work, but it's a huge disadvantage. It just shows that odd things can happen. The bumble bee shouldn't have been able to fly as well as it did, but it did.
We bought a lot of things that we just held, including a whole lot of private companies, so no capital gains taxes there. No dividend taxes. And, buying so many marketable securities that we just sat on. Not that we don't pay a lot of taxes, but we have a lot of capital gains taxes that are accrued but not paid on the balance sheet.
We made it work, but is it an intelligent system? No, it's insane. The correct system is to have a partnership. That is such an easy question, I'm surprised you asked it. Maybe you're promoting private partnerships and you knew what my answer would be. (laughter)
(5) My final option - and the one to which I lean, although not at anything like a 45-degree angle - is mildly unconventional, thereby causing somewhat more legal risk for directors.[**] It may differ from other common stock programs, more in attitude than in appearance, or even results. It involves treating portfolio management decisions much like business acquisition decisions by corporate managers.
[**] I am leaving most of the legal discussion out of this memo - partly due to space considerations and partly because it is not my field. In general, the safest course is to behave as most others are behaving - and to trust in the expertise of large, well-regarded conventional organizations. I also believe it is defensible - although not as automatically defensible - to diversify among a group of well-financed entrenched businesses purchased at reasonable valuations of earnings and assets.
The directors and officers of the company consider themselves to be quite capable of making business decisions, including decisions regarding the long-term attractiveness of specific business operations purchased at specific prices. We have made decisions to purchase several television businesses, a newspaper business, etc. And in other relationships we have made such judgments covering a much wider spectrum of business operations.
Negotiated prices for such purchases of entire businesses often are dramatically higher than stock market valuations attributable to well-managed similar operations. Longer term, rewards to owners in both cases will flow from such investments proportional to the economic results of the business. By buying small pieces of businesses through the stock market rather than entire businesses through negotiation, several disadvantages occur: (a) the right to manage, or select managers, is forfeited; (b) the right to determine dividend policy or direct the areas of internal reinvestment is absent; (c) ability to borrow long-term against the business assets (versus against the stock position) is greatly reduced; and (d) the opportunity to sell the business on a full-value, private-owner basis is forfeited.
These are important negative factors but, if a group of investments are carefully chosen at a bargain price, it can minimize the impact of a single bad experience in, say, the management area, which cannot be corrected. And occasionally there is an offsetting advantage which can be of very substantial value - but for which nothing should be paid at the time of purchase. That relates to the periodic tendency of stock markets to experience excesses which cause businesses - when changing hands in small pieces through stock transactions - to sell at prices significantly above privately-determined negotiated values. At such times, holdings may be liquidated at better prices than if the whole business were owned - and, due to the impersonal nature of securities markets, no moral stigma need be attached to dealing with such unwitting buyers.
Stock market prices may bounce wildly and irrationally but, if decisions regarding internal rates of return of the business are reasonably correct - and a small portion of the business is bought at a fraction of its private-owner value - a good return for the fund should be assured over the time span against which pension fund results should be measured.
It might be asked what the difference is between this approach and simply picking stocks a la Morgan, Scudder, Stevens, etc. It is, in large part, a matter of attitude, whereby the results of the business become the standard against which measurements are made rather than quarterly stock prices. It embodies a long time span for judgment confirmation, just as does an investment by a corporation in a major new division, plant or product. It treats stock ownership as business ownership with the corresponding adjustment in mental set. And it demands an excess of value over price paid, not merely a favorable short-term earnings or stock market outlook. General stock market considerations simply don't enter into the purchase decision.
Finally, it rests on a belief, which both seems logical and which has been borne out historically in securities markets, that intrinsic business value is the eventual prime determinant of stock prices. In the words of my former boss: "In the short run the market is a voting machine, but in the long run it is a weighing machine."
Specifically, it probably is possible to invest the $12 million in our pension fund in a dozen businesses (maybe more; ERISA emphasizes diversification) with current intrinsic value (measured by private-owner valuations and transactions) attributable to our investment of, say, $20 million and current earnings of at least $1.5 million. The portion of such earnings paid out to us clearly is worth 100 cents on the dollar, and a reasonable batting average by the managements of companies in which we invest should result in the portion reinvested having similar value. If this is the case, such a "pension division" operation will produce better returns than bond investment at current rates.
The main long-term risk would be that future returns on capital obtained by our "division managers" would turn sour. In some individual case that undoubtedly would prove true. It might well be that there also would be a favorable surprise or two. That is true of any acquisition program. The one substantial advantage that this "division" would have would be attractive purchase prices - far below those available for purchasers of entire businesses. If purchases could not be made on such a "bargain" basis, we simply would wait until they could. A second advantage would be the flexibility provided by a public stock market, allowing portions of business operations to be acquired or divested much more easily than entire operating businesses.
It must be emphasized that measurement of this program would have to be based on the progress in our share of earnings and assets of the constituent companies - not short-term market movements. We would expect substantial increases in earnings, dividends and asset values over, say, a decade just as we expect with our operating divisions at Washington Post. We would, in mental approach, have created a new diversified division, currently capitalized at about $12 million, which is expected to earn a better-than-bond rate with which to eventually pay retired employees. In a sense, this is what was done in the profit-sharing fund when it accumulated Washington Post stock throughout earlier years - basically a wise decision because the business earned very well internally and thereby grew in value at a substantial rate. It was an attractive partially-owned business, acquired at an attractive price. Until market prices were introduced, which complicated things, the funds built up through this self-owning division were significantly larger than would have been achieved by buying bonds or the general run of common stocks.
If it should be decided to implement such a policy, recommendations should be obtained from qualified analysts who clearly understand our rather unusual selection criteria. This could be handled on a quite infrequent basis.
As mentioned earlier, a policy also could be followed combining more than one option. Most combinations have been (1) and (3), or (1) and (4), but (4) and (5) could well be more logical.
The Great Financial Scandal of 2003
An Account by Charles T. Munger, Summer 2000
The great financial scandal erupted in 2003 with the sudden, deserved disgrace of Quant Technical Corporation, always called "Quant Tech". By this time, Quant Tech was the country's largest pure engineering firm, having become so as a consequence of the contributions of its legendary founder, engineer Albert Berzog Quant.
After 2003, people came to see the Quant Tech story as a sort of morality play, divided into two acts. Act One, the era of the great founding engineer, was seen as a golden age of sound values. Act Two, the era of the founder's immediate successors, was seen as the age of false values with Quant Tech becoming, in the end, a sort of latter-day Sodom or Gomorrah.
In fact, as this account will make clear, the change from good to evil did not occur all at once when Quant Tech's founder died in 1982. Much good continued after 1982, and serious evil had existed for many years prior to 1982 in the financial culture in which Quant Tech had to operate.
The Quant Tech story is best understood as a classic sort of tragedy in which a single flaw is inexorably punished by remorseless Fate. The flaw was the country's amazingly peculiar accounting treatment for employee stock options. The victims were Quant Tech and its country. The history of the Great Financial Scandal, as it actually happened, could have been written by Sophocles.
As his life ended in 1982, Albert Berzog Quant delivered to his successors and his Maker a wonderfully prosperous and useful company. The sole business of Quant Tech was designing, for fees, all over the world, a novel type of superclean and superefficient small power plant that improved electricity generation.
(3) A manager can be found handling smaller amounts whose record has been good for the right reasons.
Then hope that no one else finds him.
Good records of any type usually have attracted massive money flows - whether the record was based on unusual skill, luck, or even, occasionally, semi-fraudulent activity which has "manufactured" the record. Even those records, which I believe to have been based at least partially on skill have wilted when subjected to torrents of money.
A further problem is that in no case were the superior records I have observed based upon institutional skills, which could be maintained despite changes in the faces. Rather, the good results have been accomplished by a single individual or, at most, a few, working in fairly specialized areas in which the great bulk of investment money simply had no interest. It has been very difficult to out-think the pack on General Motors, IBM, Sears, etc. Rather, the unusual records - and there have been few that have been maintained - have been achieved by those who have worked relatively neglected fields in which competition was light.[*]
[*] Your win-loss percentage in tennis will not be determined by the absolute level of ability that you possess. Rather, it will be determined by your ability to select inferior opponents. If you select with care it will be quite easy to attain a winning percentage higher than, say, Cliff Richey while he is playing on the tour. Application of this principle is the key element in bridge, poker, or investments. (Harder to apply in the latter, however - it is easier to identify a couple of palookas at the bridge table.)
Many pension funds, including the fund to which I referred earlier, have attempted to find superior but relatively unknown managers still working with small sums. This often involves dozens of interviews and usually comes down to the past record, particularly the recent past, plus an articulate practitioner who "looks" reasonable and respectable. In my opinion, based only on impressions, the overall record from this selection process has been poor and very likely worse than the mildly below-average record of the major money manager.
The reason isn't too hard to see (particularly with a rear view mirror). Much of Wall Street is a succession of fashions. Obviously some individuals will have hit the most recent fashion, and their record will look correspondingly good maybe sensationally good if they have a reckless streak and have played a particular trend very hard. But fashion-hitting never has been successfully maintained, to my knowledge. And the manager primarily selected for recent hot performance knows what he is expected to do. He is to perform - and quickly. So the new small manager's decisions frequently are characterized by high turnover, major mistakes, even more furious activity to catch up, etc. It has not happened every time, but my hunch is that the sum total performance of the relatively unknown go-go managers for pension funds has been worse than the lumbering, stiff-legged minuet performed by the major banks.
(4) A fixed income (bonds) investment strategy can be followed, which presently allows returns of about 9% per annum that can be locked in for some time. This option currently is becoming somewhat more popular, should be quite defensible under ERISA, and will look good or bad, depending upon what returns from equity holdings develop over the next decade or two. This essentially is the same decision that was made by default several decades ago by many companies, except the rates then were 4% instead of 9%. I do not recommend an attempt by us to go back and forth from bonds to stocks. This is a skill possessed by few, if any - and certainly not by a group. If we could master this particular form of alchemy, there would be little reason to do anything else.
The comfort level produced by this option is likely to be high under any conditions except high rates of inflation - which will produce distress under all of the options discussed herein.
Finally, minimizing objectivity will help you lessen the compromises and burden of owning worldly goods because objectivity does not work only for great physicists and biologists. It also adds power to the work of a plumbing contractor in Bemidji. Therefore, if you interpret being true to yourself as requiring that you retain every notion of your youth, you will be safely underway, not only toward maximizing ignorance, but also toward whatever misery can be obtained through unpleasant experiences in business.
It is fitting that a backward sort of speech end with a backward sort of toast, inspired by Elihu Root's repeated accounts of how the dog went to Dover, “leg over leg.” To the class of 1986:
Gentlemen, may each of you rise by spending each day of a long life aiming low.
With respect to pension fund investments in securities, several paths can be followed, singly or in combination:
(1) One or more large conventional money managers may be retained, with the expectation that performance will be slightly poorer than "average" because of costs involved. If the manager is very large and conventional - any major bank will do - directors of the corporation should run no risk of imprudent behavior as fiduciaries under the new ERISA statute. Conventional behavior is safe - even when the potential litigants have the benefit of hindsight. If we should go this route, I see no reason to change from Morgan.
(2) Management in security selection can be, in essence, abandoned by simply creating a portfolio which is equivalent to "average". This minimizes turnover and management costs, and probably accomplishes about the same result as (1) - perhaps with just a touch more potential liability for results, since a tacit admission has been made that no effort is being expended to "manage". Several funds have been established fairly recently to duplicate the averages, quite explicitly embodying the principle that no management is cheaper, and slightly better than average paid management after transaction costs. This policy could be implemented by participating in such funds, or on a do-it-yourself basis.
My third prescription to you for misery is to go down and stay down when you get your first, second, or third severe reverse in the battle of life. Because there is so much adversity out there, even for the lucky and wise, this will guarantee that, in due course, you will be permanently mired in misery. Ignore at all cost the lesson contained in the accurate epitaph written for himself by Epictetus: "Here lies Epictetus, a slave, maimed in body, the ultimate in poverty, and favored by the gods."
My final prescription to you for a life of fuzzy thinking and infelicity is to ignore a story they told me when I was very young about a rustic who said, "I wish I knew where I was going to die, and then I'd never go there." Most people smile (as you did) at the rustic's ignorance and ignore his basic wisdom. If my experience is any guide, the rustic's approach is to be avoided at all cost by someone bent on misery. To help fail, you should discount as mere quirk, with no useful message, the method of the rustic, which is the same one used in Carson's speech.
What Carson did was to approach the study of how to create X by turning the question backward, that is, by studying how to create non-X. The great algebraist, Jacobi, had exactly the same approach as Carson and was known for his constant repetition of one phrase: "Invert, always invert." It is in the nature of things, as Jacobi knew, that many hard problems are best solved only when they are addressed backward. For instance, when almost everyone else was trying to revise the electromagnetic laws of Maxwell to be consistent with the motion laws of Newton, Einstein discovered special relativity as he made a 180-degree turn and revised Newton's laws to fit Maxwell's.
It is my opinion, as a certified biography nut, that Charles Robert Darwin would have ranked near the middle of the Harvard School graduating class of 1986. Yet he is now famous in the history of science. This is precisely the type of example you should learn nothing from if bent on minimizing your results from your own endowment.
Darwin's result was due in large measure to his working method, which violated all my rules for misery and particularly emphasized a backward twist in that he always gave priority attention to evidence tending to disconfirm whatever cherished and hard-won theory he already had. In contrast, most people early achieve and later intensify a tendency to process new and disconfirming information so that any original conclusion remains intact. They become people of whom Philip Wylie observed: "You couldn't squeeze a dime between what they already know and what they will never learn."
The life of Darwin demonstrates how a turtle may outrun a hare, aided by extreme objectivity, which helps the objective person end up like the only player without a blindfold in a game of Pin the tail on the Donkey.
If you minimize objectivity, you ignore not only a lesson from Darwin but also one from Einstein. Einstein said that his successful theories came from "Curiosity, concentration, perseverance, and self-criticism." And by self-criticism, he meant the testing and destruction of his own well-loved ideas.
Q: I'm Jason Zweig from The Wall Street Journal. Thanks for the free ad. If you want I can ask Rupert [Murdoch] if he'd like to reciprocate for the Daily Journal. Late in his life, Ben Graham said that in his opinion there was no reason to imagine that an individual investor who thought appropriately couldn't outperform institutions. Do you think the relative playing field has shifted? Do individuals have a greater or a lesser advantage today?
Munger: In markets as big as this, some shrewd guy who's willing to search out a few places where he has a real advantage will always do well. There are always going to be ways in markets this big for some smart people to figure out something where they'll make money at an unusual rate, just because they're smarter and more diligent. That will never go away.
I don't think there will ever be a universal easy solution where people can do that. The American market is tough now to outperform if you're buying big stocks in big quantities. I think it's a pretty damned efficient market, and I don't say it can't be done, but I just think it's plenty difficult. The evidence is overwhelming that even though there are zillions of people who have tried, the ordinary result is that they don't succeed.
I would hate the job, personally, of investing, say, in positions of a billion dollars each in 200 different stocks in America and outperforming the averages. I would shrink from that with horror. Peter Kaufman said something interesting to me the other day. He runs a very profitable company [Glenair, Inc.] that has very good returns on capital. He said, "You know, if somebody bought my company for three times sales, I wouldn't run it anymore, because I'd have a hard time justifying that price with anything I could do." He's already rich, why should he do something that difficult? He doesn't have to.
I think that's what happened in America. People know their own business is lousy. They know another business that is way better. But it's not better if you have to pay thirty times earnings for it. It gets so difficult that it doesn't work. I figured this out, but the consultants and investment bankers keep selling the same nostrum that you can save yourself by paying thirty times earnings for the kind of business you wish you had, instead of the one you've got.
Berkshire has been a huge exception. In this year's annual report Warren intends to deal extensively with: Why did it happen at Berkshire? Will it continue? We've reached a size and the record is interesting enough that those are very important questions. If the rest of the world is as smart as I think it is, it will look at this report with great interest.
Part of what we did should be done by others, but it isn't. There are vast institutional pressures on people to do it differently. Will it continue? I think Berkshire's going to continue way better than most people think. Way better. But there's so much power in what we already have. Part of the reason we have a decent record is that we pick things that are easy. Other people think they're so smart, they can take on things that are really difficult, and that proves to be dangerous. You have to be very patient, you have to wait until something comes along, which, at the price you're paying, is easy. That's contrary to human nature, just to sit there all day long doing nothing, waiting. It's easy for us, we have a lot of other things to do. But for an ordinary person, can you imagine just sitting for five years doing nothing? You don't feel active, you don't feel useful, so you do something stupid.
You'll find this year's Berkshire annual report very, very interesting. Three failing businesses together created Berkshire Hathaway. There are about the same number of shares outstanding now as they were then. I can't think of anything like it at this scale. You'd think people would be paying more attention to it than they do. I think it looks so peculiar that they can't handle it.
I read an article once by a famous man. I liked it so well (this was twenty-five years ago) that I sent him whatever I could send him without paying gift tax. I sent him $20,000 dollars and said, "I really liked your article, here's a token of my respect." He sent the money back. So, I called him and said, "Why are you sending it back to me. I don't care if you give it to your charwoman or the graduate student who works under you. For God sake's, keep the damn money." Whereby, he took my money and gave it to some graduate student. His basic attitude was, if it was that easy, there must be something wrong with it.
I think that's part of the trouble with Berkshire Hathaway. It looks so damned easy, they think there must be something wrong with it. The people there don't work that hard. They have all these outside interests - Warren's playing bridge twelve hours a week (laughter). They just keep spinning and winning and it just looks too easy. So it's confusing. There must be something wrong with it. (laughter)
2. Quality matters, in businesses and in people. Better quality businesses are more likely to grow and compound cash flow; low quality businesses often erode and even superior managers, who are difficult to identify, attract, and retain, may not be enough to save them. Always partner with highly capable managers whose interests are aligned with yours.
3. There is no need to overly diversify. Invest like you have a single, lifetime "punch card" with only 20 punches, so make each one count. Look broadly for opportunity, which can be found globally and in unexpected industries and structures.
4. Consistency and patience are crucial. Most investors are their own worst enemies. Endurance enables compounding.
5. Risk is not the same as volatility; risk results from overpaying or overestimating a company's prospects. Prices fluctuate more than value; price volatility can drive opportunity. Sacrifice some upside as necessary to protect on the downside.
6. Unprecedented events occur with some regularity, so be prepared.
7. You can make some investment mistakes and still thrive.
8. Holding cash in the absence of opportunity makes sense.
9. Favour substance over form. It doesn't matter if an investment is public or private, fractional or full ownership, or in debt, preferred shares, or common equity.
10. Candour is essential. It's important to acknowledge mistakes, act decisively, and learn from them. Good writing clarifies your own thinking and that of your fellow shareholders.
11. To the extent possible, find and retain like-minded shareholders (and for investment managers, investors) to liberate yourself from short-term performance pressures.
12. Do what you love, and you'll never work a day in your life.
Illustrations of Reality in Pension Fund Investment Management
I recently received some interesting figures from a pension fund involving about $250 million of assets. The 9-1/2 year record through June 30, 1975 of the three major banks involved (managing $20 - $50 million per bank) follows, compared to "average" as defined in two ways, the S & P 500 and the D-J Industrials:
Annual Compounded Rate of Return (including Dividends)
Dow-Jones Industrials
+2.8%
S & P 500
+3.8%
Continental Illinois
+1.8%
First National City
+1.0%
Morgan Guaranty
+3.4%
Until recently, Chase had managed a comparable segment of the funds but was terminated because of poor performance - probably worse than the other banks shown above. Each percentage point plus or minus affected this fund by about $2 to $4 million over the time period measured.
A further interesting calculation was made. On June 30, of the portfolio held by Continental, 64% of the securities held, measured by market value, also were in the Morgan portfolio and 44% were duplicated in the First National City portfolio. Similar overlap was demonstrated in other ways.
I am familiar enough with the record of this fund to state that no unusual constraints have been placed on the managers, and no special factors have to be recognized to interpret the numbers. I believe that Morgan's above-average record here, compared to that of other large banks, is typical of its relative performance at other pension funds. I also feel the predictive value of that relative standing to be low.
Pensions & Investments magazine recently rated the 35 largest banks for which five-year performance records of commingled equity funds were available. Ten did as well as or better than the S &P, consistent with what might be expected according to probability theory if everyone were operating solely according to chance and there was a modest drag on performance caused by transaction costs. More importantly, I know of no set of statistics which would demonstrate any opposite view relating to managers handling large amounts of money.
The evidence all seems to confirm that it is unwise to expect above-average investment results from a corporate pension plan, conventionally managed.
My second prescription for misery is to learn everything you possibly can from your own experience, minimizing what you learn vicariously from the good and bad experience of others, living and dead. This prescription is a sure-shot producer of misery and second-rate achievement.
You can see the results of not learning from others' mistakes by simply looking about you. How little originality there is in the common disasters of mankind - drunk driving deaths, reckless driving maimings, incurable venereal disease, conversion of bright college students into brainwashed zombies as members of destructive cults, business failures through repetition of obvious mistakes made by predecessors, various forms of crowd folly, and so on. I recommend as a memory clue to finding the way to real trouble from heedless, unoriginal error the modern saying: "If at first you don't succeed, well, so much for hang gliding."
The other aspect of avoiding vicarious wisdom is the rule for not learning from the best work done before yours. The prescription is to become as non-educated as you reasonably can.
Perhaps you will better see the type of nonmiserable result you can thus avoid if I render a short historical account. There once was a man who assiduously mastered the work of his best predecessors, despite a poor start and very tough time in analytical geometry. Eventually, his own work attracted wide attention, and he said of his work:
"If I have seen a little farther than other men, it is because I stood on the shoulders of giants."
The bones of that man lie buried now, in Westminster Abbey, under an unusual inscription:
"Here lie the remains of all that was mortal in Sir Isaac Newton."
