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Berkshire Hathaway
What Defines a Good Year?

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By hartmanbirge
December 22, 2003

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Well another year has passed and we all get to reflect on this year's market and what awaits in the year to come. There was much to be thankful for this year � an economic rebound and the corresponding rise in valuations makes all of us feel a little smarter. Most things I read refer to some annual performance number juxtaposed to a benchmark such as the S&P and then for all to see (except last year I didn't see too many!) the author will loudly proclaim how well they've done. Back to that in a second.

Each year I read several books on financial management � usually something related to Warren Buffett and I've got a running list of best book reads to accompany the usual proclamations of annual performance figures. This year the best investing book I've read is Michael Lewis's "Money Ball." Everyone talked about this book so I was suspicious that it played to some mass market psyche and wouldn't be worth the read. I was wrong. Several lessons from Billy Beane and his style of valuation analysis are certainly applicable to the investment process and how we usually go about doing things.

What Michael Lewis was able to do was graphically show how Billy Beane challenged an entire mindset. Beane took on the whole wretched establishment of baseball analysis and flipped it the bird. He developed better ways to judge real baseball talent and the whole meaning of value took on a new definition. No longer did Beane judge a player's worth by errors or batting average but rather by the obscured statistic of on base percentage and a nifty formula for measuring players on runs produced and runs surrendered which took into account a player's range in the field. All of this got me to thinking about how it was I was measuring myself in the investment arena and how Wall Street measures itself. I think the way we usually do it is wrong.

As I said at the top what we as a group and Wall Street usually do is compare an annual performance to the benchmark. The media publications and gurus will be asked for their top picks for the coming year and on we go. There are several major shortcomings with this approach. For starters the snapshot of time may not be conducive to an allocation of capital. Why is it that 1 January makes any sense to pick some company any more than say 13 July? Why is it that an annual market performance snapshot is relevant to building and maintaining long-term wealth creation? Why is it that all the gurus are asked "what's the market going to do next year?" I've come to realize that all of what we see flashed before us as performance and predictive variables really aren't all that valuable to long-term performance. So if these variables are meaningless, what does matter?

My favorite chapter in "Money Ball" was the story about the 2002 Oakland A's draft of college and high school players. With a room full of old time baseball scouts Beane basically ignored their measured wisdom and had six first round draft picks that he personally executed. Not one was a high school player. Beane did not chase lofty expectations and potential or select guys who might grow into baseball players. Instead he took proven performers from the college ranks who got on base or pitchers who had movement on their fastball instead of the usual 97mph laser. For me this is very relevant in that there tends to be a lot of hype on certain stocks that "the street" (replace with old time baseball people) loves to talk up. These companies tend to be smaller and tilted towards technology. Their potential is long and if you get the right one you've got your Darryl Strawberry rising meteor-like through your system. Just one quick read of say a Motley Fool front page and you'll see an add for Hidden Gems with tons of promise. Whitney Tilson referred to the fact that much more opportunity is to be found this coming year with smaller caps.

I consider myself to be a Billy Beane of investing. Like Beane, I cannot afford the immense research staff in terms of time and capital that it takes to sift through hundreds of stocks. I have a franchise (the HB household) which is quite limited in what I'm able to do in the arena. I've got to do things which increase my success ratio because I don't have the huge sums of capital to assume away my moonshot risks. In other words I can't afford to spend a $3 million signing bonus (or high stock price) on a high school pitcher with a 97mph fastball. I can't fill my system with high schoolers and expensive Cuban defectors in the hopes that one will hit it big. What I've got to do is play in the arena where my success ratio is high and select the right ones as they fall to me. In a typical year I may only have one or two shots but my experience shows that I WILL have one or two shots. In this I believe Tilson and others are not entirely correct to focus his readership towards the small stock universe. So what's this all mean for measuring performance? Instead of measuring myself against the S&P every year and then re-jiggering my portfolio to do it the next (Bill Miller can do that � I can't) I've got to find another way. I'm still working on it but I think my new measurement criteria will be derived from the following questions and perhaps some I've overlooked:

1) Was I able to find a superior dominant business model selling at a low price? How many were there and how many did I act on? This would be a "percentage of execution."
2) Did I execute with sufficient capital so that if I'm right it had relevance to the overall portfolio? What's the definition of "sufficient?"
3) Did I maintain my discipline and avoid the temptation of the alluring high school kid with the golden arm? This is an activity metric.....was I too active? What's "too active?"
4) What is my "batting average" of finding what I'm looking for using say a rolling five year time horizon? In other words what's my success ratio? And what's "success?" Probably beating the S&P but perhaps not.

Once I can get all of that into some quantifiable mathematical formula then I will have derived my system. At the end all of this should result in one maybe two major purchase decisions in a year while allocating at least 10-15% of my capital into those decisions (and they may well be "repeat decisions") and achieving what I hope to be a success ratio above 90%. Using a rough guide in looking back over the past year I fail miserably against my self performance metric. In the usual metric I would loudly proclaim that I BEAT THE MARKET!!!!!! Hip hip hooray!!! I was again able to identify great business models selling at attractive prices and act on them (H&R Block, Wells Fargo, Coke, Costco and Berkshire Hathaway � that was five so in this regard it was a great year). I was too active on the periphery with way too many buys and sells � using relatively small sums but all amounting to squat. My batting average on what I seek in major purchases was in a one year snapshot 100% (too early to tell however)....but there remain problems. I did not allocate enough capital to the decisions making all of this "success" not nearly as relevant as it should have been. In waiting for my picks to fall further I lost out. Wells Fargo was a success but with less than a 2% portfolio position what's it all mean? That is a failure and I can say the same for Costco and Coke. The main problem therefore is a failure to allocate sufficient capital to all of my research and conviction and in so doing I do not have the focused portfolio of 5-8 dominant franchises with enough percentage behind them to make a difference. Now all of my favorites are well above where I'd like to buy. All in all a bad year.

HB


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