Any successor to the Oracle needs Promethean vision

(Published in the South China Morning Post on 29 April 2007)

It lacks the hype that surrounds the release of a new Harry Potter novel, but as a free source of investment insight, Berkshire Hathaway's annual letter to shareholders is in a league of its own. This year's letter — issued last month and written, as always, by chairman Warren Buffett — featured a number of topics that were widely seized upon, such as the Oracle of Omaha's continued assault on the pay of hedge-fund managers and senior company executives.

While these are important issues, the real insights into Mr Buffett's investment approach are found elsewhere. The trick is to parse the 24 pages properly to glean the gems of wisdom. So much has been written about the Oracle, and yet he remains an enigma. On one level, it's how the letter is peppered with the sort of sharp wit we do not normally associate with the investing world, and certainly not with bespectacled 76-year-olds in pinstripes.

Let's face it: investing is right up there with undertaking when it comes to guffaws, maybe because both are associated with loss. Surely, equating an acquisition target with "a gorgeous blonde with a body that would cause, a bishop to go through a stained glass window" would be entirely inappropriate for a fund that just underperformed its benchmark for the second year running.

What really confounds, however, is that although Mr Buffett is invariably described as a value investor, his letter hardly makes reference to intrinsic value, the holy grail of value investing.

The VI school teaches that with detailed analysis of company accounts plus shrewd forecasting and conservative discount rates, one can calculate precisely the fair — or intrinsic — worth of a stock. When this amount is higher than the current share price, so the mantra goes, it's a great investment, the theory being that over time the stock market valuation will rise to meet the fair value.

Perhaps what has made the label so sticky is that Mr Buffett studied at Columbia University under Benjamin Graham, the father of value investing, and that there won't be an authorised biography of the Berkshire chairman until next year.

I suspect that Mr Buffett has never been in a hurry to dispel that label for the same reason that he remains quietly ecstatic that the efficient market hypothesis still features on most investment course syllabuses. Regarding that flawed theory, he notes in this year's letter: "If you are in the shipping business, it's helpful to have all your potential competitors be taught that the Earth is flat."

I am not suggesting that a young Mr Buffett took no notice of what Mr Graham, imparted so many years ago about the need to find stocks that are reasonably priced. I'm saying only that it is a given that the Oracle buys neither "overvalued" companies nor ones that he thinks are not going to grow.

What comes across more than anything in Mr Buffett's letter to shareholders is that he is an investor in managerial talent. He claims, modestly, that he takes the easy route, "sitting back and working through great managers". Terms such as "true managerial magicians", "extraordinarily talented managers" and "remarkable entrepreneur" give a very good indication of what really matters to the Oracle.

The underlying message is that unless there has been a recent speculative surge in a stock or a company's business is in decline, most firms with great management will make good long-term investments.

It is instructive that the word "manager" and its derivations are used 39 times in Berkshire's letter. That compares with zero in the US$43 billion Fidelity Magellan Fund's 2006 report, aside from the title Management's Discussion of Fund Performance and a reference to Harry Lange as the "portfolio manager". Sure, Magellan Fund's report was only 300 words long, but this in itself is revealing.

So what constitutes great management in Mr Buffett's eyes?

Energy, independent thinking and dedication, of course, but it is the less conventional that is of real interest. Mr Buffett, in the letter, relates the story of a meeting with National Fire & Marine owner Jack Ringwalt in the mid-1960s at which he was due to close the sale of his company to Berkshire Hathaway. Mr Ringwalt arrived late, explaining that he had been driving around looking for a parking meter with some unexpired time. That, for Mr Buffett, "was a magical moment for me. I knew then that Jack was going to be my kind of manager".

Another issue of interest is Mr Buffett's references to risk. In the past century, a good understanding of risk has been very elusive, mainly because uncertainty, to use its other name, is just that — uncertain.

The pioneers of modern portfolio theory chose to define risk as the volatility of stock returns, which they erroneously assumed varied according to the normal distribution curve. In fact, as the 1987 crash and the collapse of Long Term Capital Management attest, extreme events in the real world cannot be described by simple averages and standard deviations.

When writing about Berkshire's search for a successor, Mr Buffett notes: "Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never encountered before [Mr Buffett's italics]. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions."

If this describes you, Mr Buffett invites you to call him, day or night.