On Friday, May 11, 2007, Jason Zweig—who pens the “Intelligent Investor” column for the Wall Street Journal—was interviewed by my friend and former Barron’s editor, Kate Welling.[1]
Coincidentally, on the preceding Saturday, I was in Nebraska, packed in among the thousands drawn to figuratively sit at the feet of the Oracle of Omaha, Warren Buffett, and his taciturn partner, Charlie Munger. Unlike most everyone else at the Berkshire Annual Meeting, my presence was not entirely as a spectator. Having written my firm’s annual report in February, I was looking for confirmation of my conviction that risks were proliferating throughout the capital markets. So, in the company of a packed house of my fellow shareholders, I asked Warren the following question.[2]
Warren, having read and reread your (2006) chairman’s letter, I was particularly struck by your “help wanted” ad for an eventual successor to you and Lou Simpson to oversee Berkshire’s investments in marketable securities. Instead of advertising for a Ted Williams—the Hall of Famer to whom you often refer because of his rational approach to becoming a hitting legend—you proposed to recruit the consummate defensive player. Here are your words, and I quote: “We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions” [emphasis added].
In a world where everyone’s talking about return, you talk about risk. What I inferred from this job description, your warnings on derivatives, the dollar, executive compensation, the “Gotrocks” family and its “handlers,” your preference for private deals over publicly traded stocks, among others, is that in general since 1999 your assessment of the investment environment in marketable securities does not appear to be radically different from how you felt exactly 30 years ago, when you more or less took a multi-year hiatus from marketable securities because you simply didn’t like the odds. Am I reading you correctly? I would hope that Charlie might give his two cents’ worth as well.
This was neither the first nor the last question I’d I pose to Buffett in that very public forum over the years. (It was a lot cheaper than buying his lunch!) Thus, I was under no illusion that his answer would be anything other than obtuse:
When I closed the Buffett Partnership, I felt (and wrote to my investors) that the prospective return was about the same for equities and municipal bonds over the next decade, and I was roughly right. It’s not the same today. I’d have 100 percent in short-term bonds. Forced to choose between owning the S&P 500 vs. 20-year bonds, I’d buy stocks—and it would not be a close decision. But I wouldn’t have an equity investment with someone who charged high fees. We don’t have the faintest idea where the S&P or bonds will be in three years, but over 20 years we’d prefer to own stocks.
I was anything but crestfallen. What he put in print during the winter of 2007 had been indelible warning enough. The fact that he sidestepped my question entirely—slipping into his familiar refrain that stocks beat bonds over the long term—was all the confirmation I needed. In the following month, I embarked on the best trade of my investment career (so far 😊).[3]
The Brain of Warren Buffett
So what role does Jason Zweig play in all this? When I got around to reading Welling’s repartee with Zweig, I was intrigued that he delved into brain science when attempting to dissect Buffett’s perennial success. Zweig argued that Buffett’s “inverse emotionalism” is as potent a force as his purported rationality. He contended that Buffett’s capacity to be greedy when other people are fearful and fearful when other people are greedy is evidence of his brain’s knack to “generate emotions backwards.” This predisposition, Zweig continued, was common to Benjamin Graham and Charlie Munger as well. When most investors panic as the market goes down, “They see opportunity and they actually get kind of a pleasure from knowing they’re doing the right thing when everyone else they can see around them is clearly doing the wrong thing.”
Throughout human evolution, being hardwired to avoid scary things and get excited about good things has kept our species from extinction. Judged by that standard, Buffett’s response is abnormal. A sociopath, instead of feeling remorse, may actually derive pleasure from things that make others uncomfortable. While that likely overstates the dynamic of inverse emotionalism, a young relative said of Ben Graham: “He was very humane, but not very human.”
It can be argued that great investors remain unbothered by things that bother most people. It’s a capacity beyond calm. It is imperturbable, even implacable.
I sense a broader application to Zweig’s observation. When Buffett is asked about his investment prowess, his response is, invariably, “Rationality.” While mean reversion has its genesis in the physical world, could it perhaps be roughly applied to the psychological as well? The swing between greed and fear are the extremes of psychological mean reversion. Perhaps Buffett’s “rationality” is the businessman’s analog to emotional implacability. He knows that whenever emotions swing too far in one direction, they will, in due time, reverse course.
Brain scientists contend that the emotional part of the brain is highly active in short-term decision making but has almost no involvement in long-term decisions. This makes intuitive sense. As I observe players in the market, the long-term future doesn’t carry much weight; it simply is too abstract. But it’s the power of our short-term emotions that gets so many investors in trouble. Buffett-like, long-term investors are playing in a space where there isn’t much competition. Unfortunately for most managers, the short-term performance mandate (a.k.a. career risk) precludes them from going to where the risks are lower and the returns higher. Lest we forget, Buffett enjoys a huge advantage because he oversees permanent capital and therefore can live in the long-term space without threat of asset attrition through redemptions.
As an outsider, I’m in no position to opine with authority on the extent to which Buffett took his own advice proffered in his 2006 chairman’s letter. Given what he subsequently wrote about the crisis, though, it doesn’t appear that he anticipated the severity or the immediacy of the risk. After all, who did? Moreover, given the 25/75 mix between marked-to-market equity holdings and the book value of Berkshire subsidiaries, for the most part his hedging options were limited, if necessary.
Buffett’s inverse emotionalism, however, is on full display in both the 2008 and 2009 reports as he bought equities and sold puts. It was the same response he had in 1963 when he purchased the pummeled shares of American Express after the infamous salad-oil scandal had been exposed. While he’s not quite so bold today, it’s clear he hasn’t lost his game.
That said, the post-crisis period has been progressively tougher on value investors like Buffett, Seth Klarman, and us. Although the chart below leaves much unsaid, it says enough.
Beyond Buffett
Over the long run, success in the money-management business does not go to people who are conventional, and it’s probably only by separating yourself from the pack, with a longer-term horizon, that you’re able to prevail.
As a top-down analyst, my focus has been economics, fiscal and monetary policy, and overall market valuation, among other variables. Given that grounding, my written record would suggest that I’m relatively imperturbable.
Moving to the bottom-up—if for no other reason than time constraints—the universe of companies I follow closely is limited. By contrast, the managers of our recent affiliate, Palm Valley Capital Management, monitor a 200–300 company “buy list.” There are significant advantages in knowing everything about a company long before you ever buy it. If there’s a negative earnings surprise or some other factor that drives the stock down, you will be in the best position to determine whether the selloff is reasonable or an overreaction.
If you know the value of a business,
said Ben Graham, when the price drops, you can be ready. That enables you to
realize that your margin of safety just got wider at the exact moment when just
about everyone else has panicked. By being prepared, you can counteract the
tendency of your own brain to feel panicky. You can have a lot more confidence
that you are doing the right thing and get the satisfaction of doing it when most
others are doing the opposite. Thus, you can actually structure your investment
decision making so that you function as if you are inversely emotional—without
having to deal with the stigma outside the office!
[1] Interview from Welling’s newsletter, Welling@Weeden. In September of that year, Zweig, with whom I’ve been casually acquainted for a long time, published Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich.
[2] Frank K. Martin. A Decade of Delusions: From Speculative Contagion to the Great Recession (Wiley, 2011), 340–341.
[3] Ibid, chapter 10.