Insights from an investment manager at Berkshire Hathaway

In its 32nd edition of the annual Graham & Dodd Breakfast, Columbia Business School invited Todd Combs (an investment manager at Berkshire Hathaway and CEO of GEICO) to be the guest speaker. An alumnus of Columbia Business School, Todd ran a hedge fund before Warren Buffett swooped him in 2010. He was made the CEO of GEICO (a Berkshire subsidiary) in 2019. Held in New York City every year, the breakfast brings together alumni, students, scholars, and practitioners for a forum on current insights and approaches to investing. As the forum is a private event, we have relied upon a blog that covered the event.

His first interaction with Charlie Munger
The first question Charlie asked Todd was what percentage of S&P 500 companies would be a better business in five years' time. Todd answered that less than 5 per cent would be better. To that, Charlie replied that less than 2 per cent would be better. Charlie stated that a business that is great today need not become better in five years. The rate of change in the world is significant and that makes this exercise difficult.

A litmus test used by Warren Buffett
Todd often visits Warren on Saturdays to talk about various investments. He mentioned a litmus test that they frequently use. Warren would ask, "How many companies in the S&P 500 are going to be 15 times earnings (i.e., P/E of 15) in the next 12 months? How many are going to earn more in five years (using a 90 per cent confidence interval) and how many would compound at 7 per cent (using a 50 per cent confidence interval)?" This exercise allows th1em to solve for cyclicality, compounding, and valuation. It was used to find Apple.

On moats (or competitive advantage)
Todd says that a question that is constantly asked (usually daily) at Berkshire is whether the moat is widening or narrowing for any of their businesses. The worst business grows and needs infinite capital with declining returns. The best business grows exponentially with no capital.

Todd's approach
He says that there is a lot of outside in. You hear a narrative, you meet with the management and that is intellectually dishonest. The goal of investing is to have intellectual purity. There are facts and numbers, and then there is a narrative. He tries to distance himself from the narrative until he has a view. He forms a view without looking at the market cap. Then he thinks about the future of the company and pressure tests his assumptions.

Some tools to evaluate businesses

• The focus is on the owner's earnings (i.e., reported earnings plus depreciation and amortisation and certain other non-cash charges less capital expenditure less additional working capital). He says that it is a good sign when the owner's earnings are close to the reported earnings.
• An aspect that is not well understood and properly evaluated is maintenance capex. He says that CEOs have a very low grasp of their maintenance capex. He adds that most management teams are not even able to have that discussion because of their confidence in investing for growth. In reality, management often is mistaking growth for something that is really maintenance capex.
• Todd said that it's a red flag if a company is too focused on external relations. If management is incentivised to appeal to Wall Street, it might behave in a value-destructive way.
• He also talked about how he focuses on delta reports and sees what management is changing from year to year. He cited the example of Bear Stearns (a former investment bank). In 2005, the company changed something very essential in their reports while saying something different to the street.
• Another big red flag is when management changes the key performance indicators for which it will get compensated. This is done because the management won't get compensated if the indicators are left as is.
• While Warren and Todd don't try to predict the macroeconomic outlook, they also don't extrapolate the current environment. Always invert, he says. For instance, in a deflationary environment, they would ask how a business would perform in 10 per cent inflation.

On valuation
Todd stated that you have to have a framework where you are getting a financial return. Sometimes earnings are misleading. David Einhorn (an American investor) once wrote, he says, that there's an arbitrage in situations when most people are focused solely on financial metrics, you need to adjust for accounting which can be extremely misleading. He gave the example of software-as-a-service businesses that incur 100 cents on the dollar in expenses on day one and going forward earn whatever the LTV (lifetime value) of the customer is. He further explains, "in the early days of Walmart and Amazon, I wouldn't focus on the fact that the reserves seemed wrong and quite large. Look at where it took them. I build out unit economics (in the case of Walmart look at the individual store), and that is your north star. You backtrack, and you get to CAC (customer acquisition cost), LTV, and so on."

To some degree, when valuing a business, Todd suggests disregarding the financial statements and accounting and focusing your attention on unit economics. After figuring out unit economics, the first thing he does is evaluate P/E, and then understand the owner's earnings. "Look at where you're at in the lifecycle of the company, and where it is. Then let's look at where it is going and apply some confidence intervals."

Learnings from management meetings
Whenever Todd meets a publicly-listed company's management, he asks two questions - (1) how long do they spend talking to investors? and (2) what would they be doing if they were not publicly traded? He stated that the median response is 25 per cent of the time is spent talking to investors. In response to the second question, management usually lists a number of things that make a lot of sense, and when Todd asks why they don't do that, they say because they feel handcuffed. The management's focus on quarterly performance means that they are not empowered to do the right thing.

Suggested read:
Warren Buffett's obscure valuation method
Insights from Howard Marks' latest memo

This article was originally published on December 12, 2022.