Chong Ser Jing, Author at The Good Investors : Page 16 of 23

What Cancer Can Teach Us About Investing

The field of cancer research shows us that simple but highly effective things are often overlooked. It’s the same in investing.

Cancer and investing are topics that seem so distant. But you can learn a lot about something by studying other areas and finding parallels. There’s an important lesson that cancer can teach us about investing.

Simple way to win cancer

Robert Weinberg is an expert on cancer research from the Massachusetts Institute of Technology. In the documentary The Emperor of All Maladies, Weinberg said (emphases are mine):

“If you don’t get cancer, you’re not going to die from it. That’s a simple truth that we [doctors and medical researchers] sometimes overlook because it’s intellectually not very stimulating and exciting.

Persuading somebody to quit smoking is a psychological exercise. It has nothing to do with molecules and genes and cells, and so people like me are essentially uninterested in it – in spite of the fact that stopping people from smoking will have vastly more effect on cancer mortality than anything I could hope to do in my own lifetime.”

Studying mutations, DNA, and cutting-edge drugs to find ways to beat cancer is engaging and fascinating for scientists and physicians. But it’s not necessarily the most effective way to defeat the dreadful disease. Unfortunately, what is really effective – simple prevention – is largely ignored because it is so simple.

Similarly, I have observed that investors seem to often ignore the simple because they favour the complex.

Simple way to win the investing game

Ben Carlson helps manage the investment plans for institutions such as foundations, endowments, pensions, and more. He’s also an excellent financial blogger – check out his blog A Wealth of Common Sense.

In a 2017 blog post, Carlson compared the long-term returns of US college endowment funds against a simple portfolio he called the Bogle Model.

The Bogle Model was named after one of my investment heroes, the late index fund legend John Bogle. It consisted of three, simple, low-cost Vanguard funds that track US stocks, stocks outside of the US, and bonds. In the Bogle Model, the funds were held in these weightings: 40% for the US stocks fund, 20% for the international stocks fund, and 40% for the bonds fund.

Meanwhile, the college endowment funds were dizzyingly complex. Here’s Carlson’s description:

“These funds are invested in venture capital, private equity, infrastructure, private real estate, timber, the best hedge funds money can buy; they have access to the best stock and bond fund managers; they use leverage; they invest in complicated derivatives; they use the biggest and most connected consultants…”

Over the 10 years ended 30 June 2016, the Bogle Model produced an annual return of 6.0%. But even the college endowment funds that belonged to the top-decile in terms of return only produced an annual gain of 5.4% on average. The simple Bogle Model had bested nearly all the fancy-pants college endowment funds in the US.

K.I.S.S (Keep it simple, silly!)

One of my favourite stories about the usefulness of simplicity in investing comes from an old 1981 speech by investor Dean Williams. In his speech – one of the best investment speeches I’ve come across – Williams shared the story of the fund manager Edgerton Welch (emphasis is mine):

“You are familiar with the periodic rankings of past investment results published in Pension & Investment Age. You may have missed the news that for the last ten years the best investment record in the country belonged to the Citizens Bank and Trust Company of Chillicothe, Missouri.

Forbes magazine did not miss it, though, and sent a reporter to Chillicothe to find the genius responsible for it. He found a 72 year old man named Edgerton Welsh, who said he’d never heard of Benjamin Graham and didn’t have any idea what modern portfolio theory was. “Well, how did you do it?” the reporter wanted to know.

Mr. Welch showed the report his copy of Value-Line and said he bought all the stocks ranked “1” that Merrill Lynch or E.F. Hutton also liked. And when any one of the three changed their ratings, he sold. Mr. Welch said, “It’s like owning a computer. When you get the printout, use the figures to make a decision–not your own impulse.”

The Forbes reporter finally concluded, “His secret isn’t the system but his own consistency.” EXACTLY. That is what Garfield Drew, the market writer, meant forty years ago when he said, “In fact, simplicity or singleness of approach is a greatly underestimated factor of market success.””

My own investing process can also be boiled down to a simple sentence: Finding great companies that can grow at high rates for a long period of time. I focus on understanding individual companies, and I effectively ignore interest rates and most other macroeconomic developments. It has served me well.

Taking lessons from cancer research, as investors, we should never overlook a simple investment idea or process just because it’s intellectually uninteresting. Simple can win in investing.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

What We’re Reading (Week Ending 10 May 2020)

The best articles we’ve read in recent times on a wide range of topics, including investing, business, and the world in general.

We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!

But since our readership-audience for The Good Investors is wider than our subscriber base, we think sharing the reading list regularly on the blog itself can benefit even more people. The articles we share touch on a wide range of topics, including investing, business, and the world in general.

Here are the articles for the week ending 10 May 2020:

1. How To Achieve 12,000% Returns Against The Odds – Chin Hui Leong

The table below is a sample of stocks that I have held for nine years or more.

The returns may look phenomenal now… but the outlook was not like that over a decade ago….

There I was, in the middle of the Global Financial Crisis, back in early 2008, a downturn so severe that it was eventually billed as the worst recession to happen in over 50 years.

Things were looking bad. Really bad.

And there I was, right in the centre of the economic storm.

If today’s COVID-19 economic scenario feels similar, you might want to stick around for what I am about to share.

2. Why Isn’t The Market Down More? – Sean Stannard-Stockton

The most important thing to keep in mind is that S&P 500 is often referred to as “the market,” but of course the S&P 500 is essentially the 500 largest companies in the US, which, especially during this crisis, are not indicative of the economy as a whole. And the largest 25 companies make up nearly 40% of the S&P 500…

…Now whatever you think about those companies, most all investors would agree that they are far, far more likely to survive this crisis than the average company. And, in fact, with so many smaller companies struggling it seems very likely that many of these large companies will thrive in a post-Coronavirus world in which their competition has been dealt a huge setback.

So looked at this way, the fact that the S&P 500 is only down 16% from its highs does not suggest that the market thinks the economy will be OK, but rather that the largest companies in the world will see their way though, and as demand returns they will face much less competition.

If instead, the market was reflecting investors being naively optimistic about the economic impact of Coronavirus, then you would expect to see economically sensitive stocks leading the recovery. But the reverse is true.

3. Scientists Create Jet Engine Powered By Only Electricity – Dan Robitzski

A prototype jet engine can propel itself without using any fossil fuels, potentially paving the way for carbon-neutral air travel.

The device compresses air and ionizes it with microwaves, generating plasma that thrusts it forward, according to research published Tuesday in the journal AIP Advances. That means planes may someday fly using just electricity and the air around them as fuel.

4. What Have We Learned Here? – Morgan Housel

The two most important economic stories are the size of the business collapse and the magnitude of the stimulus. It’s easy to focus on the former because it’s personal and devastating while ignoring the latter because it’s political and hard to contextualize. But they are equally huge. Despite 15% unemployment, Goldman Sachs estimates household income will be higher in Q2 2020 than it was in Q2 2019, largely because of stimulus…

…Done right, forecasting is a delicate balance of probabilities. But people want certainty, especially when the stakes are high. The people who make forecasting models probably have less faith in their accuracy than those who read them, if only because things like confidence intervals are rarely discussed in the media.

5. Inside the Biggest Oil Meltdown in History – Leah McGrath Goodman

Many of the market participants caught in the crossfire were not sophisticated investors, but simply members of the retail public who did not understand how oil futures contracts work — and that they can expire or trade negative.

When pressed about these investors’ portfolio losses, CME chairman Terrence Duffy, who appeared on CNBC in the aftermath of negative oil prices, did not mince words. “Futures contracts have been around for hundreds of years and I will tell you, since Day 1, everybody knows that it’s unlimited losses in futures,” he said. “So nobody should be under the perception that it can’t go below zero.”

6. Owning Stocks is a Long-Term Project – Safal Niveshak

“Mountains should be climbed with as little effort as possible and without desire. The reality of your own nature should determine the speed. If you become restless, speed up. If you become winded, slow down. You climb the mountain in an equilibrium between restlessness and exhaustion. Then, when you are no longer thinking ahead, each footstep isn’t just a means to an an end but a unique event in itself. This leaf has jagged edges. This rock looks loose. From this place the snow is less visible, even though closer. These are things you should notice anyway. To live only for some future goal is shallow. It’s the sides of the mountain that sustain life, not the top. Here’s where things grow.”

7. Why Most Post-Pandemic Predictions Will Be Totally Wrong – Rob Walker

When a cataclysmic event is fresh or still unfolding, it’s hard to see beyond its immediate contours and even harder to imagine what the next unpredictable events will be and how those will affect whatever change is in motion right now. As this moment ought to remind us, the most influential and important events are the ones that emerge spontaneously and with little warning — like the coronavirus itself.

But it’s so seductively easy to double down on sweeping pronouncements: E-sports will replace football and basketball, movie theaters will never return, and telemedicine will become the new normal. (We’ve even made a few.)

Anything is possible, but take a closer look at how often definitive predictions about permanent change are simply extrapolations of recently observable trends taken to some maximum extreme.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

How To Evaluate A Company’s Management Team

How can we evaluate a company’s management team? It’s not an easy thing to do. But here are some examples of management teams that I think are great.

I spend a lot of time to evaluate a company’s management team in my investment research process. I’m also often asked by people I meet what I look out for in management. There’s no formula, but I tend to look for company leaders who have a different way of looking at the world.

I think it’ll be useful to share a few great examples from the companies that are in my family’s investment portfolio.

Example 1

Mark Zuckerberg is the CEO and co-founder of Facebook (NASDAQ: FB). In the company’s IPO prospectus, Zuckerberg wrote these words in a shareholders’ letter:

“Facebook was not originally created to be a company. It was built to accomplish a social mission — to make the world more open and connected.

We think it’s important that everyone who invests in Facebook understands what this mission means to us, how we make decisions and why we do the things we do.”

This is what Zuckerberg said in the company’s 2020 first-quarter earnings conference call:

“I have always believed that in times of economic downturn, the right thing to do is to keep investing in building the future, and I believe this for a few reasons.

First, when the world changes quickly, people have new needs and that means that there are more new segments to build. Second, since many big companies will pull back on their investments, there are a lot of things that wouldn’t otherwise get built, but that we can help deliver. And the third, I believe that there is a sense of responsibility and duty to invest in the economic recovery and to provide stability for your community and stakeholders if you have the ability to do so.

And we’re in a fortunate position to be able to do this. Along with our strong financial position and the important social value our services provide, we’re planning to hire at least 10,000 more people in product and engineering roles this year, so we can continue building and making progress…

…Overall, I think during a period like this there are a lot of new things that need to get built. And I think it’s important that rather than slamming on the brakes now, as I think a lot of companies may, that it’s important to keep on building and keep on investing in building for the new need that people have and especially to make up for some of the stuffs that that other companies would pullback on, and I think that’s in some ways that’s an opportunity, in other ways, I think it’s responsibility to keep on investing in the economic recovery.”

Example 2

Amazon.com’s (NASDAQ: AMZN) founder and CEO, Jeff Bezos, said the following in a 2011 interview with Wired magazine:

“Our first shareholder letter, in 1997, was entitled, “It’s all about the long term.” If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people.

But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that. Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue. At Amazon we like things to work in five to seven years. We’re willing to plant seeds, let them grow – and we’re very stubborn. We say we’re stubborn on vision and flexible on details.”

Bezos also mentioned this in Amazon’s 2020 first-quarter earnings update:

“We are inspired by all the essential workers we see doing their jobs — nurses and doctors, grocery store cashiers, police officers, and our own extraordinary frontline employees. The service we provide has never been more critical, and the people doing the frontline work — our employees and all the contractors throughout our supply chain — are counting on us to keep them safe as they do that work. We’re not going to let them down. Providing for customers and protecting employees as this crisis continues for more months is going to take skill, humility, invention, and money.

If you’re a shareowner in Amazon, you may want to take a seat, because we’re not thinking small. Under normal circumstances, in this coming Q2, we’d expect to make some [US]$4 billion or more in operating profit. But these aren’t normal circumstances. Instead, we expect to spend the entirety of that [US]$4 billion, and perhaps a bit more, on COVID-related expenses getting products to customers and keeping employees safe. This includes investments in personal protective equipment, enhanced cleaning of our facilities, less efficient process paths that better allow for effective social distancing, higher wages for hourly teams, and hundreds of millions to develop our own COVID-19 testing capabilities.

There is a lot of uncertainty in the world right now, and the best investment we can make is in the safety and well-being of our hundreds of thousands of employees. I’m confident that our long-term oriented shareowners will understand and embrace our approach, and that in fact they would expect no less.” [Yes, I do expect no less from Amazon, as one of the company’s shareholders.]

Example 3

Warren Buffett, the CEO of Berkshire Hathaway (NYSE: BRK-A)(NYSE: BRK-B) wrote the following in his 2004 shareholders’ letter:

“What we’ve had going for us is a managerial mindset that most insurers find impossible to replicate. Take a look at the facing page. Can you imagine any public company embracing a business model that would lead to the decline in revenue that we experienced from 1986 through 1999? That colossal slide, it should be emphasized, did not occur because business was unobtainable. Many billions of premium dollars were readily available to NICO [National Indemnity Company] had we only been willing to cut prices. But we instead consistently priced to make a profit, not to match our most optimistic competitor. We never left customers – but they left us.”

In Berkshire Hathaway’s 1994 shareholders’ letter, Buffett wrote one of my all-time favourite passages in investing literature:

“We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%.

But, surprise – none of these blockbuster events made the slightest dent in Ben Graham’s investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.

A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results.”

Example 4

Netflix (NASDAQ: NFLX) co-founder and CEO Reed Hastings said the following in a 2007 interview with Fortune magazine, when streaming was about to take off:

“We named the company Netflix for a reason; we didn’t name it DVDs-by-mail. The opportunity for Netflix online arrives when we can deliver content to the TV without any intermediary device.”

Netflix also has a letter named Long-Term View. The letter has these passages:

“We compete for a share of members’ time and spending for relaxation and stimulation, against linear networks, pay-per-view content, DVD watching, other internet networks, video gaming, web browsing, magazine reading, video piracy, and much more. Over the coming years, most of these forms of entertainment will improve.

If you think of your own behavior any evening or weekend in the last month when you did not watch Netflix, you will understand how broad and vigorous our competition is.

We strive to win more of our members’ “moments of truth”.”

Example 5

In a 2015 letter, Shopify’s (NYSE: SHOP) co-founder and CEO Tobi Lütke wrote:

“Over the years we’ve also helped foster a large ecosystem that has grown up around Shopify. App developers, design agencies, and theme designers have built businesses of their own by creating value for merchants on the Shopify platform. Instead of stifling this enthusiastic pool of talent and carving out the profits for ourselves, we’ve made a point of supporting our partners and aligning their interests with our own. In order to build long-term value, we decided to forgo short-term revenue opportunities and nurture the people who were putting their trust in Shopify. As a result, today there are thousands of partners that have built businesses around Shopify by creating custom apps, custom themes, or any number of other services for Shopify merchants.

This is a prime example of how we approach value and something that potential investors must understand: we do not chase revenue as the primary driver of our business. Shopify has been about empowering merchants since it was founded, and we have always prioritized long-term value over short- term revenue opportunities. We don’t see this changing.”

Example 6

Chipotle Mexican Grill’s (NYSE: CMG) IPO prospectus contained the following passages:

“When Chipotle (pronounced chi-POAT-lay) opened its first restaurant in 1993, the idea was simple: demonstrate that food served fast didn’t have to be a “fast-food” experience. We use high-quality raw ingredients, classic cooking methods and a distinctive interior design, and have friendly people to take care of each customer—features that are more frequently found in the world of fine dining.

When we opened, there wasn’t an industry category to describe what we were doing. Some 12 years and more than 500 company-operated and franchised restaurants later, we compete in a category of dining now called “fast-casual,” the fastest growing segment of the restaurant industry, where customers expect food quality that’s more in line with full-service restaurants, coupled with the speed and convenience of fast food.”

The prospectus also said:

“Our focus has always been on using the kinds of higher-quality ingredients and cooking techniques used in high-end restaurants to make great food accessible at reasonable prices. But our vision has evolved. While using a variety of fresh ingredients remains the foundation of our menu, we believe that “fresh is not enough, anymore.” Now we want to know where all of our ingredients come from, so that we can be sure they are as flavorful as possible while understanding the environmental and societal impact of our business. We call this idea “food with integrity,” and it guides how we run our business.

Using higher-quality ingredients: We use a variety of ingredients that we purchase from carefully selected suppliers. We concentrate on where we obtain each ingredient, and this has become a cornerstone of our continuous effort to improve our food. Some of the ingredients we use include naturally raised pork, beef and chicken, as well as organically grown and sustainably grown produce, and we continue to investigate using even more naturally raised, organically grown and sustainably grown ingredients, in light of pricing considerations.

A few things, thousands of ways: We only serve a few things: burritos, burrito bols (a burrito without the tortilla), tacos and salads. We plan to keep a simple menu, but we’ll always consider sensible additions. For example, we introduced the burrito bol in 2003—just when the popularity of low carbohydrate diets exploded—and estimate that we sold about seven million of them in that year. In 2005, we also rolled out a salad.

We believe that our focus on “food with integrity” will resonate with customers as the public becomes increasingly aware of, and concerned about, what they eat.”

Chipotle was at one point owned by fast food giant McDonald’s, and there was a huge clash between them in terms of how they approached their food culture. Two quotes from a brilliant Bloomberg profile of Chipotle’s entire history from 1993 to 2014 clearly illustrates the differences between the two companies:

1. “What we found at the end of the day was that culturally we’re very different. There are two big things that we do differently. One is the way we approach food, and the other is the way we approach our people culture. It’s the combination of those things that I think make us successful.”

2. “Our food cost is what runs in a very upscale restaurant, which was really hard for McDonald’s. They’d say, “Gosh guys, why are you running 30 percent to 32 percent food costs? That’s ridiculous; that’s like a steakhouse.”

Sticking with great leaders makes sense

It’s impossible to get it right all the time when we evaluate a company’s management team. There can also be times when our assessment of a company’s leaders turn out to be right, but bad luck ends up causing the investment to sour. These things happen. But by and large, if we can find wonderful management teams and stick with them, we may be pleasantly surprised at the returns we can find.

Here’s a look at the return my family’s portfolio has earned from each of the six stocks mentioned above since our first purchase of their shares:

I’ve said in a few recent webinars I’ve done (here’s one of them) that I consider a company’s management team to be the ultimate source of a company’s competitive advantage. That’s because a company’s current economic moats come from management’s past actions, while a company’s future economic moats come from management’s current actions. And the beautiful thing about having a unique lens to view the world is that it is a trait that is not easily – or perhaps never can be – copied.

My Favourite Warren Buffett Comments From The 2020 Berkshire Hathaway AGM

On 2 May 2020, Warren Buffett presided over the 2020 Berkshire Hathaway AGM (annual general meeting). Here are my favourite comments from him.

Warren Buffett is one of my investment heroes. I’ve been a shareholder of the company that he runs, Berkshire Hathaway (NYSE: BRK-A)(NYSE: BRK-B), since August 2011. On 2 May 2020, Buffett held court at the 2020 Berkshire Hathaway AGM (annual general meeting).

For many years, I’ve anticipated the AGM to hear his latest thoughts. This year was no exception for me. In fact, the 2020 Berkshire Hathaway AGM held even more importance, given the uncertainty that the global economy is currently facing because of the COVID-19 pandemic.

I got up at 4am on the morning of 3 May 2020 (I live in Singapore) to watch the live-stream of the entire event. It was surreal, seeing shots of a completely empty stadium that would in normal times hold tens of thousands of people. Moreover, the meeting did not have Charlie Munger, Buffett’s long-time sidekick. Berkshire thought that it did not make sense for Munger to fly from California to Omaha for the meeting. Instead, Greg Abel – who runs Berkshire’s non-insurance businesses – sat at the podium with Buffett.

But I wasn’t disappointed by this year’s AGM. The whole event lasted for over four hours. Buffett kicked it off with a tour-de-force presentation on the history and future of the US economy. He then tackled a whole host of questions – collated from the public and asked by CNBC host Becky Quick – together with Abel.

I thought it would be worth sharing my favourite comments from Buffett and Abel.

Betting on the future of the US

Warren Buffett: “In 2008 and 2009, our economic train went off the tracks, and there were some reasons why the road-bed was weak in terms of the banks and all of that sort of thing. But this time, we just pulled the train off the tracks and put it on the side.

And I don’t really know of any parallel of one of the most important countries in the world – the most productive, with a huge population – in effect, sidelining its economy and its workforce. And obviously and unavoidably, creating a huge amount of anxiety and changing people’s psyche and causing them to somewhat lose their bearings, in many cases understandably.

This is quite an experiment, and we may know the answer to most of the questions reasonably soon, but we may not know the answers to some very important questions for many years. So it still has this enormous range of possibilities.

But even facing that, I would like to talk to you about the economic future of the country because I remain convinced as I have. I was convinced of this in World War II, I was convinced of this during the Cuban Missile Crisis, 9/11, the financial crisis – that nothing can basically stop America. And we faced great problems in the past. We haven’t faced this exact problem. In fact, we haven’t really faced any that quite resembles this problem. But we faced tougher problems. And the American miracle, the American magic has always prevailed, and it will do so again.”

The importance of deposit insurance

Warren Buffett: “And one of the things as I look back on that period [referring to the Great Depression] – and I don’t think the economists generally like to give it that much of a point of importance – but if we had the FDIC [Federal Deposit Insurance Corporation] 10 years earlier… The FDIC started on January 1, 1934. It was part of the sweeping legislation that took place when Roosevelt came in. If we had the FDIC, we would have had a much, much different experience, I believe, in the Great Depression.

There was Smoot-Hawley – I mean, there’s all kinds of things and the margin requirements in ’29 and all of those things entered into creating a recession. But if you have over 4,000 banks fail, that’s 4,000 local experiences where people save and save and save and put their money away, and then someday, they reach for it and it’s gone. And that happens in all 48 states, and it happens to your neighbors, and it happens to your relatives. It has an effect on the psyche that’s incredible.

So one very, very, very good thing that came out of the Depression, in my view, is the FDIC. And it would have been a somewhat different world, I’m sure, if the bank failures hadn’t just rolled across this country – and with people who thought that they were savers, find out that they had nothing when they went there and there was a sign that said “Closed.”

Incidentally, the FDIC – I think very few people know this, or at least, they don’t appreciate it. But the FDIC has not cost the American taxpayer a dime. I mean its expenses have been paid, its losses have been paid, all through assessments on banks. It’s been a mutual insurance company of the banks backed by the federal government, associated with the federal government. But now it holds [US]$100 billion, and it consists of premiums that were paid in and investment income on the premium less the expenses and paying off all the losses. And think of the incredible amount of peace of mind that’s given to people that were not similarly situated when the Great Depression hit.”

The US stock market and economy’s incredible rise

Warren Buffett: “I remember 1954 because it was the best year I ever had in the stock market. And the Dow went from essentially 280 or thereabouts at the start of the year to a little over 400 at the end of the year.

And when it went to 400 – as soon as it crossed 381, that famous figure from 1929 – and this will be hard for some of you to believe, but everybody wondered: Is this 1929 all over again? And that seemed a little far-fetched because it was a different country in 1954. But that was the common question.

It actually achieved such a level of worry about whether we were about to jump off another cliff because the 381 [high] of 1929 had been exceeded that they had Senator Fulbright – Will Fulbright of Arkansas, who became very famous later in the Foreign Relations Committee. But he had set up a Banking Committee, and he called for a special investigation – if you read through it, he really was questioning whether we had built another house of cards again. And on this committee, one of the members was Prescott Bush, the father of George H. W. Bush, and grandfather of George W. Bush. It had some illustrious names.

And his committee in March of 1955, with the Dow at 405, assembled 20 of the best minds in the United States to testify as to whether we were going crazy again because the market was at 400, the Dow was at 400, and we’ve gotten in this incredible trouble before. But that was the mindset of the country. It’s incredible. We didn’t really believe America was what it was.

The reason I’m familiar with this thousand-page book that I have here – they found it last night in the library – was that I was working in New York for 1 of the 20 people who was called down to testify before Senator Fulbright. And he testified right before Bill Martin (who was running the Federal Reserve) testified and right after General Wood (who was running Sears) testified. And Bill Martin, of course, is the longest-running Chairman in the history of the Fed, and he’s the one who gave the famous quote that “The function of the Fed was to take away the punch bowls just when the party starts to get really warmed up.” But Ben Graham, my boss, sent me over to the public library in New York to gather some information, something you could do in 5 minutes with the computer now. I dug out something, and he went to testify.

And on Page 545 of this book — I knew where to look. I didn’t have to go through it all. But he had the quote, which I remember. And I remember because Ben Graham was 1 of the 3 smartest people I’ve met in my life. He was the Dean of the people in the securities business. He wrote the classic Security Analysis book in 1934. He wrote the book that changed my life, The Intelligent Investor, in 1949. He was unbelievably smart. And when he testified with the Dow at 404, he had one line in there toward the start in his written testimony. He said, “The stock market is high. Looks high. It is high, but it’s not as high as it looks.” But he said it is high.

And since that time, of course, we felt the American tailwind at full force. And the Dow is about 24,000. So you’re looking at a market today that has produced $100 for every dollar. All you did was you had to believe in America – just buy a cross section of America. You didn’t have to read the Wall Street Journal. You didn’t have to look up the price of your stock. You didn’t have to pay a lot of money in fees to anybody. You just had to believe that the American miracle was intact.

But you had this testing period between 1929 and 1954 as indicated by what happened when it got back up to 380. You had this testing period. And people – they’d lost faith to some degree. They just didn’t see the potential of what America could do. And we found that nothing can stop America when you get right down to it. And it’s been true all along. They have been interrupted. One of the scariest of scenarios was when you had a war with one group of states fighting another group of states, and it may have been tested again in the Great Depression, and it may be tested now to some degree. But in the end, the answer is never bet against America, and that in my view is true today as it was in 1789 and even was true during the Civil War and in the depths of the Depression.”

The right way to approach stocks

Warren Buffett: “Imagine for a moment that you decided to invest money now and you bought a farm. Let’s say about 160 acres, and you bought it $X per acre. And the farmer next to you has 160 identical acres – same contour, same quality of soil. So it was identical. But that farmer next door to you is a very peculiar character. Every day that farmer with the identical farm says “I’ll sell you my farm or I’ll buy your farm at a certain price,” which he would name.

Now that’s a very obliging neighbor. I mean that’s got to be a plus to have a fellow like that in the next farm. You don’t get that with farms. You get it with stocks. You want 100 shares of General Motors on Monday morning, somebody will buy your 100 shares or sell you another 100 shares at exactly the same price, and that goes on 5 days a week. But just imagine if you had a farmer doing that.

When you bought the farm, you looked at what the farm would produce. That was what went through your mind. You were saying to yourself, “I’m paying $X per acre, I think I’ll get so many bushels of corn or soybeans. On average, some years, good; some years, bad; some years, the price will be good; some years, the price will be bad; etc.” But you think about the potential of the farm.

And now you get this idiot that buys a farm next to you. And on top of that, he’s sort of manic depressive. And he drinks, maybe smokes a little pot. So his numbers just go all over the place. Now the only thing you have to do is to remember that this guy next door is there to serve you and not to instruct you. You bought the farm because you thought the farm had the potential. You don’t really need a quote on it. If you bought in with John D. Rockefeller or Andrew Carnegie, there were never any quotes, although there were quotes later on. But basically, you bought into the business.

That’s what you’re doing when you buy stocks, but you get this added advantage. You have this neighbor who you’re not obliged to listen to at all, but who is going to give you a price every day. And he’s going to have his ups and downs, and maybe he’ll name his selling price that he’ll buy at, in which case you sell if you want to; or maybe he’ll name a very low price, and you’ll buy his farm from him. But you don’t have to, and you don’t want to put yourself in a position where you have to. So stocks have this enormous inherent advantage of people yelling out prices all the time to you, and many people turn that into a disadvantage.

And of course, many people profit in one way or another from telling you that they can tell you what your neighboring farmer’s going to yell out tomorrow or next week or next month. There’s huge money in it. So people tell you that it’s important and they know and that you should pay a lot of attention to their thoughts about what price changes should be, or you tell yourself that there should be this great difference.

But the truth is if you own the businesses you liked prior to the virus arriving – it changes prices, but nobody is forcing you to sell. And if you really like the business and you like the management you’re in with, and the business hasn’t fundamentally changed – and I’ll get to that little one report on Berkshire, which I will soon, I promise – the stocks have an enormous advantage.

And you still can bet on America. But you can’t do that, unless you’re willing and have an outlook to independently decide that you want to own a cross section of America because I don’t think most people are in a position to pick single stocks. A few maybe. But on balance, I think people are much better off buying a cross section of America and just forgetting about it. If you’ve done that – if I’d done that when I got out of college, it’s all I had to do to make 100 on 1 and then collect dividends on top of it, which increased substantially over time.”

More on the right approach to stocks

Warren Buffett: “The American tailwind is marvelous. But it’s going to have interruptions and you’re not going to foresee the interruptions. And you do not want to get yourself in a position where those interruptions can affect you, either because you’re leveraged or because you’re psychologically unable to handle looking at a bunch of numbers.

If you really had a farm and you had this neighbor. And Monday, he offered you $2,000 an acre. And the next day, he offers you $1,200 an acre. And maybe the day after that, he offers you $800 an acre. Are you really going to – at $2,000 an acre when you had evaluated what the farm would produce – going to let this guy drive you into thinking “I better sell because his number keeps coming in lower all the time”? It’s a very, very, very important matter to bring the right psychological approach to owning common stocks.

But I will tell you, if you bet on America and sustain that position for decades, you’re going to do – in my view – far better than owning Treasury securities, or far better than following people who tell you what the farmer is going to yell out next. There’re huge amounts of money that people pay for advice they really don’t need. And for the person giving it, it can be very well-meaning and they believe their own line. But the truth is that you can’t deliver superior results to everybody by just having them trade around a business. A business is going to deliver what the business produces. And the idea that you can outsmart the person next to you or the person advising you can outsmart the person sitting next to you – well, it’s really the wrong approach.”

Even more on the right way to approach stocks

Warren Buffett: “I’m not saying that this is the right time to buy stocks – if you mean by “right” that they’re going to go up instead of down. I don’t know where they’re going to go in the next day or week or month or year, but I hope I know enough to know.

Well, I think I can buy a cross section and do fine over 20 or 30 years, and I think that’s kind of an optimistic viewpoint. But I hope that really, everybody would buy stocks with the idea that they’re buying partnerships and businesses and they wouldn’t look at them as chips to move around up or down.”

On integrity

Warren Buffett: “I would never take real chances with other people’s money under any circumstances. Both Charlie [Munger] and I come from a background where we ran partnerships. I started mine in 1956 for seven either actual family members or the equivalent. And Charlie did the same thing 6 years later.

And neither one of us, I think — I know I didn’t and I’m virtually certain the same is true of Charlie – neither one of us ever had a single institution investment with us. The money we managed for other people was from individuals, people with faces attached to them, or entities’ money with faces attached to them.

We’ve always felt that our job is basically that of a trustee, and hopefully a reasonably smart trustee in terms of what we were trying to accomplish. But the trustee aspect has been very important. It’s true for the people with the structured settlements. It’s true for up and down the line, but it’s true for the owners very much, too. So we always operate from a position of strength.”

Why Buffett thinks he holds a lot more investments than people generally think, and why he keeps a lot of cash

Warren Buffett: “I show our cash and Treasury bills, positioned on March 31. And you might look at that and say, well, you’ve got [US]$125 billion or so in cash and treasury bills, and you’ve got — at least at that point, [US]$180 billion or so in equities. And you can say, well, that’s a huge position having Treasury bills versus just [US]$180 billion in equities. But we really have far more than that in equities because we own a lot of businesses. We own 100% of the stock of a great many businesses, which to us are very similar to the marketable stocks we own – we just don’t own them all. We don’t have a quote on them. But we have hundreds of billions of wholly owned businesses.

So there are [US]$124 billion – it’s not some 40% or so cash position. It’s far less than that. And we will always keep plenty of cash on hand for any circumstances. When the 9/11 comes along, if the stock market is closed as it was in World War I – it’s not going to be, but I didn’t think we were going to be having a pandemic when I watched that Creighton-Villanova game in January either.

So we want to be in a position at Berkshire where – you remember Blanche DuBois in A Streetcar Named Desire that goes back before many of you. In Blanche’s case, she said that she’s dependent on the kindness of strangers. And we don’t want to be dependent on the kindness of friends even, because there are times when money almost stops. And we had one of those, interestingly enough. We had it, of course, in 2008 and ’09 but right around the day or two leading up to March 23rd, we came very close. But fortunately, we had a Federal Reserve that knew what to do. But investment-grade companies were essentially going to be frozen out of the market.”

It’s a bad idea to borrow to juice returns

Warren Buffett: “CFOs all over the country have been taught to sort of maximize returns on equity capital, so they would finance themselves – to some extent – with commercial paper because that was very cheap. And it was backed up by bank lines and all of that. And they let the debt creep up quite a bit in many companies.

And then, of course, they all were scared by what was happening in markets [in March 2020], particularly the equity markets. And so they rushed to draw down lines of credit, and that surprised the people who had extended those lines of credit. They got very nervous. And the capacity of Wall Street to absorb a rush to liquidity that was taking place in mid-March was strained to the point where the Federal Reserve, observing these markets, decided they had to move in a very big way.

We got to the point where the US treasury market, the deepest of all markets, got somewhat disorganized. And when that happens, believe me, every bank and CFO in the country knows it. And they react with fear, and fear is the most contagious disease you can imagine. It makes the virus look like a piker [a North American term referring to a gambler who makes only small bets].”

Praise for the Federal Reserve

Warren Buffett: “We came very close [in March 2020] to having a total freeze of credit to the largest companies in the world who were depending on it. To the great credit of Jay Powell.

I’ve always had Paul Volcker up on a special place, a special pedestal in terms of Federal Reserve chairmen over the years. We’ve had a lot of very good Fed Chairman. But Paul Volcker, I had him at the top of the list. And I’ll recommend another book. Paul Volcker died about less than maybe a year ago, or a little less. But not much before he died, he wrote a book called Keeping At It. And if you call my friends at The Bookworm, I think you’ll enjoy reading that book. Paul Volcker was a giant in many ways, and he was a big guy, too. He and Jay Powell couldn’t see more in temperament or anything.

But Jay Powell, in my view, and the Fed board – I put him up there on that pedestal because with him, they acted in the middle of March, probably somewhat instructed by what they had seen in 2008 and ’09. They reacted in a huge way and essentially allowed what’s happened since that time to play out the way it has.

In March, the market had essentially frozen. But in a little after mid-month, it ended up – because the Fed took these actions on March 23 – it ended up being the largest month for corporate debt issuance, I believe, in history. And then April followed through with an even larger month. And you saw all kinds of companies grabbing everything coming to market. And spreads actually narrowed.

Every one of those people that issued bonds in late March and April should send a thank you letter to the Fed because it would not have happened if they hadn’t operated with really unprecedented speed and determination.”

Unknown consequences from the Fed’s actions

Warren Buffett: “We’ll know the consequences of swelling the Fed’s balance sheet. You can look at the Fed’s balance sheet. They put it out every Thursday. It’s kind of interesting reading, if you’re sort of a nut like me. But it’s up there on the Internet every Thursday, and you’ll see some extraordinary changes there in the last 6 or 7 weeks.

And like I say, we don’t know the consequences of that, and nobody does exactly. We don’t know the consequences of what undoubtedly we’ll have to do – but we do know the consequences of doing nothing. That would have been the tendency of the Fed in many years past – not doing nothing, but doing something inadequate. But Mario Draghi brought the “whatever it takes” to Europe. And the Fed in mid-March sort of did “whatever it takes squared”, and we owe them a huge thank you.

But we’re prepared at Berkshire. We always prepare on the basis that maybe the Fed will not have a Chairman that acts like that. And we really want to be prepared for anything. So that explains some of the [US]$124 billion in cash and bills. We don’t need it all. But we do never want to be dependent on not only the kindness of strangers, but the kindness of friends.”

Why Buffett thought his airline investments were a mistake

Warren Buffett: “You’ll see in the month of April that we net sold [US]$6 billion or so of securities. That isn’t because we thought the stock market was going to go down or because somebody changed their target price or they changed this year’s earnings forecast. I just decided that I’d made a mistake in evaluating – that was an understandable mistake, it was a probability-weighted decision when we bought.

We were getting an attractive amount for our money when investing across the airlines business. So we bought roughly 10% of the four largest airlines, and – this is not 100% of what we did in April – but we probably paid somewhere between [US]$7 billion and [US]$8 billion to own 10% of the four large companies in the airline business [in the US]. And we felt for that, we were roughly getting [US]$1 billion of earnings. Now, we weren’t getting [US]$1 billion of dividends, but we felt our share of the underlying earnings was [US]$1 billion. And we felt that that number was more likely to go up than down over a period of time. It would be cyclical, obviously. But it was as if we bought the whole company, but we bought it through the New York Stock Exchange. We can only effectively buy 10%, roughly, of the four. We treat it mentally exactly as if we were buying a business.

It turned out I was wrong about that business because of something that was not in any way the fault of four excellent CEOs. Believe me, there’s no joy being a CEO of an airline. But the companies we bought were well managed. They did a lot of things right. That’s a very, very, very difficult business because you’re dealing with millions of people every day. And if something goes wrong for 1% of them, they are very unhappy. So I don’t envy anybody the job of being CEO of an airline. But I particularly don’t enjoy them being in a period like this where people have been told basically not to fly. I’ve been told not to fly for a while. I’m looking forward to flying – I may not fly commercial, but that’s another question.

The airline business – I may be wrong, and I hope I’m wrong – but I think it changed in a very major way. And it’s obviously changed in the fact that the four companies are each going to borrow perhaps an average of at least [US]$10 billion or [US]$12 billion each. Well, you have to pay that back out of earnings over some period of time. I mean you’re [US]$10 billion or [US]$12 billion worse off if that happens. And of course, in some cases, they’re having to sell stock or sell the right to buy a stock at these prices, and that takes away from them the upside.

And I don’t know whether 2 or 3 years from now that as many people will fly as many passenger miles as they did last year. They may and they may not. The future is much less clear to me about how the business will turn out through absolutely no fault of the airlines themselves. A low-probability event happened, and it happened to hurt the travel business, the hotel business, cruise business, theme park business, but particularly the airline business. And of course, the airline business has the problem that if the business comes back 70% or 80%, the aircraft don’t disappear. So you’ve got too many planes. And it didn’t look that way when the orders were placed a few months ago and arrangements were made. But the world changed for airlines and I wish them well.”

Preparing for the worst

Becky Quick: ”Okay. The next question comes from Robert Tomas from Toronto, Canada. And he says, “Warren, why are you recommending listeners to buy now, yet you’re not comfortable buying now as evidenced by your huge cash position?”

Warren Buffett: “Well, (A) as I explained, the position isn’t that huge when I look at worst-case possibilities. I would say that there are things that I think are quite improbable. And I hope they don’t happen, but that doesn’t mean they won’t happen. For example, in our insurance business, we could have the world’s or the country’s Number 1 hurricane that it’s ever had – but that doesn’t preclude the fact we’re going to have the biggest earthquake a month later. So we don’t prepare ourselves for a single problem. We prepare ourselves for problems that sometimes create their own momentum.

In 2008 and ’09, you didn’t see all the problems the first day. What really kicked it off was when Freddie and Fannie – the GSEs [government-sponsored enterprises] – went into conservatorship in early September and then when money market funds broke the buck. I mean there are things to trip other things, and we take very much a worst-case scenario into mind that probably is considerably worse than most people do. So I don’t look at it as huge.”

Thoughts on capital allocation

Becky Quick: “Greg, let me ask you one of these capital allocation questions. This one comes from Matt Libel. And he says, Berkshire directed 46% of capital expenditure in 2019 to Berkshire Hathaway Energy. Can you walk us through with round numbers how you think differences in capex spending versus economic depreciation versus GAAP depreciation and help explain the time frame over which we should recognize the contracted return on equity from these large investments as we as shareholders are making in Berkshire Hathaway Energy?”

Greg Abel: “Right. So when we look at Berkshire Hathaway Energy and their capital programs, we try to really look at — look at it in a couple of different packages.

One, what does it actually require to maintain the existing assets for the next 10, 20, 30 years, i.e. it’s not incremental. It’s effectively maintaining the asset, the reflection of depreciation. And our goal is always to clearly understand across our businesses, do we have businesses that require more than our depreciation or equal or less? And I’m happy to say with the assets we have in place and how we’ve maintained the energy assets, we generally look at our depreciation as being more than adequate if we deploy it back into capital to maintain the asset.

Now the unique thing in the lion’s share of our energy businesses that are regulated, and that exceeds 85% of them – 83% of them – we still earn on that capital we deploy back into that business. So it’s not a traditional model where you’re putting it in, but you’re effectively putting it in to maintain your existing earnings stream. So it’s not drastically different, but we do earn on that capital.

But what we do spend a lot of time on – when Warren and I think about the substantial amounts of opportunities, that’s incremental capital that is truly needed within new opportunities. So it’s to build incremental wind, incremental transmission that services the wind, or other types of renewable solar. That’s all incremental to the business and drives incremental, both growth in the business – it does require capital – but it does drive growth within the energy business. So there’s really the 2 buckets. I think we would use a number a little bit lower than the depreciation. We’re comfortable the business can be maintained at that level. And as we deploy amounts above that, we really do view that as “incremental or growth capex”.”

Warren Buffett: “Yes, we have what, [US]$40 billion or something? What do we have kind of in the works?”

Greg Abel: “Well, yes. So we have basically, as Warren is highlighting, [US]$40 billion in the works of capital. That’s over the next, effectively, 9-year, 10-year period. Approximately half of that, we would view as maintaining our assets. A little more than half of it is truly incremental. But those are known projects we’re going to move forward with. And I would be happy to report, we probably have another [US]$30 billion that aren’t far off of becoming real opportunities in that business.

So as Warren said, that takes a long time. It’s a lot of work. The transmission projects, for example, that we’re finishing in 2020 were initiated in 2008 when we bought PacifiCorp. I remember working on that transmission plant, putting it together, thinking 6 to 8 years from now, we’ll have them in operation. 12 years later – and over that period of time, we earn on that capital we have invested and then when it comes into service, we earn on the whole amount. So we’re very pleased with the opportunity. We plant a lot of seeds, put it that way.”

Warren Buffett: “Yes. And it’s not like they’re super high-return, but they’re decent returns over time. And we’re almost uniquely situated to deploy the capital – I mean you could have government entities do it too, but in terms of the private enterprise. They take a long time. They earn decent returns. I’ve always said about the energy business: It’s not a way to get real rich, but it’s a way to stay real rich.

We will deploy a lot of money at decent returns, not super returns. You shouldn’t earn super returns on that sort of thing. You are getting rights to do certain things that governmental authorities are authorizing and they should protect consumers – but they also should protect people that put up the capital. It’s worked now for 20 years and it’s got a long runway ahead.”

The risks of investing in oil & gas companies

Becky Quick: “Let me follow-up with this one, and this one comes in from Amish Bal, who says, “Is there a risk of permanent loss of capital in the oil equity investment?””

Warren Buffett: “Well, there certainly is. There’s no question. If oil stays at these prices, there’s going to be a whole lot of money – and it will extend to bank loans and it will affect the banking industry to some degree. It doesn’t destroy them or anything, but there’s a lot of money that’s been invested that was not invested based on a [US]$17 or [US]$20 or [US]$25 price for WTI, West Texas Intermediate oil. But you can do the same thing in copper and you can do the same thing in some of the things we manufacture. But with commodities, it’s particularly dramatic. Farmers have been getting lousy prices, but to some extent, the government subsidized them. I’m all for it, actually.

But if you’re an oil producer, you take your chances on future prices unless you want to sell a lot of futures forward. OXY [Occidental Petroleum] actually did sell 300,000 barrels a day of puts in effect – or they bought puts and sold calls in effect to match it. And they were protected for a layer of [US]$10 a barrel on 300,000 barrels a day. But when you buy oil, you’re betting on oil prices over time and over a long time. And there’s risk, and the risk is being realized by oil producers as we speak. If these prices prevail, there will be a lot of bad loans and bad debts in energy loans. And if there are bad debts in energy loans, you can imagine what happens to the equity holders. So yes, there’s a risk.”

Effects of negative interest rates on Berkshire’s insurance business

Becky Quick: “All right. This question comes from Rob Grandish in Washington, D.C. He says “Interest rates are negative in much of Europe, also in Japan. Warren has written many times that the value of Berkshire’s insurance companies derived from the fact that policyholders pay upfront, creating insurance float on which Berkshire gets to earn interest.

If interest rates are negative, then collecting money upfront will be costly rather than profitable. If interest rates are negative, then the insurance float is no longer a benefit but a liability. Can you please discuss how Berkshire’s insurance companies would respond if interest rates became negative in the United States?””

Warren Buffett: “Well, if they were going to be negative for a long time, you better own equities. You better own something other than debt. I mean it’s remarkable what’s happened in the last 10 years. I’ve been wrong in thinking that – you could really have had the developments we’ve had without inflation taking hold.

But we have [US]$120-odd billion — well, we have a very high percentage in treasury bills — in cash. Those treasury bills are paying us virtually nothing. They’re a terrible investment over time. But they are the one thing that when opportunity arises – it will arise at the time and it may be the only thing you can look to, to pay for those opportunities, is the treasury bills you have. I mean, the rest of the world may have stopped. And we also need them to be sure that we can pay the liabilities we have in terms of policyholders over time. And we take that very seriously.

So if the world turns into a world where you can issue more and more money and have negative interest rates over time, I’d have to see it to believe it. But I’ve seen a little bit of it and I’ve been surprised, so I’ve been wrong so far. I would say this, if you can have negative interest rates and pour out money and incur more and more debt relative to productive capacity, you’d think the world would have discovered it in the first couple of thousand years rather than just coming onto it now. But we will see.

It’s probably the most interesting question I’ve ever seen in economics: Can you keep doing what we’re doing now? And we’ve been able to do it. The world has been able to do it for now, a dozen years or so. But we may be facing a period where we’re testing that hypothesis that you can continue it with a lot more force than we’ve tested it before. Greg, do you have any thoughts on that? I wish I knew the answer, maybe you do.”

Greg Abel: “No, I think as you articulated – I think it was in the annual report too – we don’t know the answer. But as you said, some of the fundamentals right now are very interesting relative to having a negative interest rate. But no, I hate to say it, but I don’t have anything to add.”

Warren Buffett: “I’d love to be Secretary of Treasury, if I knew I can keep raising money at negative interest rates. That makes life pretty simple. We’re doing things that we really don’t know the ultimate outcome. And I think in general, they’re the right things, but I don’t think they’re without consequences. And I think they could be kind of extreme consequences if pushed far enough, but there would be kind of extreme consequences if we didn’t do it as well. So somebody has to balance those questions.”

The risk of the US government defaulting on its debt

Becky Quick: “All right. This question comes from Charlie Wang. He’s a shareholder in San Francisco. He says, “Given the unprecedented time of the economy and the debt level, could there be any risks and consequences of the U.S. government defaulting on its bonds?””

Warren Buffett: “No. If you print bonds in your own currency, what happens to the currency is that it can be a question because you don’t default. And the United States has been smart enough – and people have trusted us enough – to issue its debt in its own currency. And Argentina is now having a problem because the debt isn’t in their own currency and lots of countries have had that problem, and lots of countries will have that problem in the future. It’s very painful to owe money in somebody else’s currency.

Listen, if I could issue a currency – Buffett bucks – and I had a printing press, and I could borrow money in that, I would never default. So what you end up getting in terms of purchasing power can be in doubt. But in terms of the US government.. When Standard & Poor’s downgraded the United States government – I think it was Standard & Poor’s, some years back – that, to me, did not make sense. How you can regard any corporation as stronger than the person who can print the money to pay you, I just don’t understand. So don’t worry about the government defaulting.

I think it’s kind of crazy incidentally. This should be said. To have these limits on the debt and all of that sort of thing, and then stopped-government arguing about whether it’s going to increase the limits – we’re going to increase the limits on the debt. The debt isn’t going to be paid, it’s going to be refinanced. And anybody that thinks they’re going to bring down the national debt.. I mean there’s been brief periods and I think it’s in the late ’90s or thereabouts, when it has come down a little bit. The country is going to grow in terms of its debt-paying capacity. But the trick is to keep borrowing in your own currency.”

How to detect malfeasance in banks, and the current state of the banking industry in the US

Becky Quick: “This is one that comes from Thomas Lin in Taiwan. He says, “Warren once said that banking is a good business if you don’t do dumb things on the asset side. Given that the pandemic might put a lot of pressure on the loans, dumb things that got done in the past few years are likely to explode. Through reading annual reports, 10-Qs and other public information, what clues are you looking for to decide whether a bank is run by a true banker who avoids doing dumb things?””

Warren Buffett: “That’s a very good question. But I would say that the one thing that made Chairman Powell’s job a little easier this time than it was in 2008-09 is that the banks are in far better shape. So in terms of thinking about what was good for the economy, he wasn’t at the same time worrying about what he was going to do with Bank A or Bank B, to merge them with somebody else, or put added strains on the system or anything.

The banks were very involved with a problem in 2008 and ’09. They had done some things they shouldn’t have done in some of them. And they were certainly in far different financial condition. So the banking system is not the problem in this particular — I mean, we decided as a people to shut down part of the economy in a big way. And it was not the fault of anyone that it happened. Things do happen in this word. Earthquakes happen. Huge hurricanes happen. This was something different.

But the banks need regulation. I mean they benefit from the FDIC. But part of having the government standing behind your deposits is to behave well, and I think that the banks have behaved very well. And I think they’re in very good shape. That’s how the FDIC has built up the [US]$100 billion that I’ve talked about. They’ve assessed the banks in recent years at accelerated amounts in certain periods, and they even differentiated against the big banks. So they built up great reserves there. And they built their own balance sheets, and they are not presently part of Chairman Powell’s problem, whereas they were very much part of Chairman Bernanke’s problem back in 2008 and ’09.

How will you spot the people that are doing the dumb things? It’s not easy – well, sometimes it’s easy. But I don’t see a lot that bothers me. But banks are, in the end, institutions that operate with significant amounts of other people’s money. And if problems become severe enough in an economy, even strong banks can be under a lot of stress and we’ll be very glad we’ve got the Federal Reserve system standing behind them. I don’t see special problems in the banking industry.

Now I could think of possibilities, and Jamie Dimon referred to this a little bit in the JPMorgan report. You can dream of scenarios that put a lot of strain on banks. They’re not totally impossible – that’s why we have the Fed. I think overall, the banking system is not going to be the problem. But I wouldn’t say that with 100% certainty because there are certain possibilities that exist in this world where banks can have problems. They’re going to have problems with energy loans. They’re going to have extra problems with consumer credit. But they know it, and they’re well reserved – well, they’re well capitalized for it. They were reserve-building in the first quarter, and they may need to build more reserves, but they are not a primary worry of mine at all. We own a lot of banks, or we own a lot of bank stocks.”

Recognising heroes and making sure no one’s left behind

Becky Quick: “Warren, this question comes from Bill Murray, the actor, who is also a shareholder in Berkshire. He says “This pandemic will graduate a new class of war veterans, health care, food supply, deliveries, community services. So many owe so much to these few. How might this great country take our turn and care for all of them?”

Warren Buffett: “Well, we won’t be able to pay actually – it’s like people that landed at Normandy or something. The poor, the disadvantaged, they suffer – there’s an unimaginable suffering. And at the same time, they’re doing all these things – they’re working 24-hour days and we don’t even know their names. So we ought to – if we go overboard on something, we ought to do things that can help those people.

This country – I’ve said this a lot of times before – we are a rich, rich, rich country. And the people that are doing the kind of work that Bill talks about, they’re contributing a whole lot more than some of the people that came out of the right womb, or got lucky and things, or know how to arbitrage bonds or whatever it may be. In a large part, I’m one of those guys. So you really try to create a society that under normal conditions with more than [US]$60,000 of GDP per capita, that anybody that works 40 hours a week can have a decent life without a second job and with a couple of kids. They can’t live like kings, I don’t mean that, but nobody should be left behind.

It’s like a rich family. You find rich families and they have 5 heirs or 6 heirs. They try and pick maybe the most able one to run the business. But they don’t forget about the kid that actually may be a better citizen in some ways than even the one that does the best at business, but they just don’t happen to have market-value skills. So I do not think a very rich company ought to totally abide by what the market dishes out in 18th-Century style or something of the sort.

So I welcome ideas that go in that direction. We’ve gone in that direction. We did come up with social security in the ’30s. We’ve made some progress. But we ought to – we have become very, very, very rich as a country. Things have improved for the bottom 20%. You see various statistics on that. I’d rather be in the bottom 20% now than be in the bottom 20% 100 years ago or 50 years ago. But what’s really improved is the top 1% – and I hope we, as a country, move in a direction where people Bill’s talking about get treated better. And it isn’t going to hurt the country’s growth and it’s overdue. A lot of things are overdue.

I will still say we’re a better society than we were 100 years ago. But you would think with our prosperity, we would hold ourselves to even higher standards of taking care of our fellow man, particularly when you see a situation like you’ve got today where it’s the people whose names you don’t know that are watching the people come in and watching the bodies go out. Greg?”

Greg Abel: “Yes. The only other group that I would highlight – I think it will be very interesting how it plays out – is with the number of home schooling and the children that are home. We’ve always had so much respect for teachers, but we all talk about how we don’t take care of them. And it is remarkable to hear how many people comment that, clearly, we don’t recognize – I have a little 8-year old back at home and plenty of challenges for Mom – but all of a sudden, you respect the institution, the school, the teachers and everything around it.

And then when I think of our companies and the delivery employees we have, it’s absolutely amazing what they’re doing. They’re truly on the front line. That’s where we have our challenges around keeping their health and safety. And then you go all the way to the rail. The best videos you see out of our companies are when we have folks that are actively engaged in moving supplies, food, medical products – and they’re so proud of it. They recognize they’re making a difference. So a lot of it is we just owe them a great thanks.

And Warren, you touched on it, we can, in some way, maybe, hopefully longer-term, compensate them. But there’s a great deal of thanks, and I probably just think an immense amount of new appreciation for a variety of folks.”

Warren Buffett: “We’re going in the right direction all around the country but it’s been awfully slow.”

Is capitalism broken?

Becky Quick: “Gentlemen, I’ll make this the last question. It comes from Phil King. He says “Many people in the press and politics are questioning the validity of capitalism. What can you say to them that might prompt them to take a look at capitalism more favorably?”

Warren Buffett: “Well, the market system works wonders, but it’s also brutal if left entirely to itself. We wouldn’t be the country we are, if the market system hadn’t been allowed to function. And you can say that other countries around the world that have improved their way of life dramatically, to some extent, have copied us.

So the market system is marvelous in many respects. But it needs government. It is creative destruction. But for the ones who are destroyed, it can be a very brutal game, for the people who work in the industries and all that sort of thing. So I do not want to come up with anything different than capitalism, but I certainly do not want unfettered capitalism.I don’t think we’ll move away from it, but I think… Capitalists, I’m one of them. I think there’s a lot of thought that should be given to what would happen if we all draw straws again for particular market-based skills.

Somewhere way back, somebody invented television, I don’t know who it was. And then they invented cable, then they invented pay systems and all of that. And so a fellow who could bat 0.406 in 1941 was worth [US]$20,000 a year. And now a marginal Big Leaguer will make vastly greater sums because in effect, the stadium size was increased from 30,000 or 40,000 or 50,000 people, to the country. The market system – capitalism – took over. And it’s very uneven, and in same way – I think that Ted Williams is worth a lot more money than I’ve ever should make. But the market system can work toward a winner-takes-all type situation. And we don’t want to discourage people from working hard and thinking.

But that alone doesn’t do it, there’s a lot of randomness in the capitalist system, including inherited wealth. I think we can keep the best parts of a market system and capitalism and we can do a better job of making sure that everybody participates in the prosperity that that produces. Greg?”

Greg Abel: “I think it’s always keeping the best parts of it. I even think if we look at the current environment we’re in – the pandemic – and we have to do it only when we can do it properly and reemerge. But in some ways, the best opportunity for people is when we’re back working clearly and that the system is functioning again. But that’s the obvious. And Warren, you’ve highlighted, there’s a lot of imperfections, but it’s definitely the best model out there that just needs some fine tuning.”

The amazing Ben Graham

Becky Quick: “Can I just slip in one more quick question? I forgot this one, someone sent it in earlier. Anderson Hexton wrote in. He said: “Warren mentioned that Ben Graham is one of the three smartest people he’s ever met. I’d like to ask him the names of the other two.””

Warren Buffett: “[Laughs] Well, I may not be one of the smartest, but I’m smart enough not to name the other two. I make only two people happy.

Ben Graham is one of the smartest people, and I know some really smart people. Smartness does not necessarily equate to wisdom, either. And Ben Graham, one of the things he said he liked to do every day was he wanted to do something creative, something generous, and something foolish. And he said he was pretty good at the latter, but he was pretty good. He was amazing, actually.”

Closing remark: Never bet against America

Warren Buffett: “And Becky, I would just say again that – I hope we don’t – but we may get some unpleasant surprises. And we are dealing with a virus that spreads its wings in a certain way, in very unpredictable ways and how all Americans react to it. There’s all kinds of possibilities, but I definitely come to the conclusion after weighing all that, sort of – never bet against America. So thanks.”

Webinar: “3 Stocks To Watch In These Chaotic Times”

A webinar where my friends (Stanley Lim and Sudhan P) and I shared three stocks to watch during this COVID-19 crisis, and answered questions from viewers.

My friend Stanley Lim organised a special webinar session on 28 April 2020 for Value Invest Asia, the excellent investment education site that he’s leading. The participants in the webinar were Stanley, Sudhan P., and myself. During the webinar, the three of us talked about our favourite stock ideas at the moment, and also answered the questions of viewers.

We covered a lot of ground during the webinar and it was a wonderful session of sharing. I’ve known Stanley and Sudhan for years. They are my ex-colleagues (we worked together for many years in Motley Fool Singapore) and are excellent investors in their own right. More importantly, they are my friends. Sudhan is currently a content strategist at the highly popular Singapore-based personal finance portal, Seedly, specialising in creating investing-related content.

You can find a video of our webinar below. We talked about three stocks:

Amazon (NASDAQ: AMZN): 7:23 minute mark
Tencent Holdings (700:HK): 33:00 minute mark
Micro-Mechanics (SGX:5DD): 53:41 minute mark

The questions we answered touched on the following:

Amazon’s future growth drivers
Amazon’s valuation
Different valuation tool kits
Tencent’s biggest risk, and the risk of its VIE (variable interest entity) structure
Is Tencent still hampered by the Chinese government’s refusal to approve online games?
Tencent’s growth rate
Risk of fraud for China-based companies, such as what happened to Luckin Coffee (NASDAQ: LK)
How to handle fraud cases in the stock market
Tencent’s market share
COVID-19’s impact on Micro-Mechanics’s business
The risk of Micro-Mechanics cutting its dividend
Micro-Mechanics’s economic moat
The cyclicality of Micro-Mechanics’s business and of the semiconductor industry
Finding the courage to start investing
Are we too early to bottom fish?
Should we be concerned about small differences in our purchase prices for stocks?

Enjoy our discussion! (The video starts at the 2:00 minute mark and there is a lag in the video for the first 10 minutes; sorry for the technical issue!)

The Simple Secret To Investing That This Unique Retail Company Holds

Costco is an example of a simple secret to investing: A competitive advantage can come from simply doing what others are unable or unwilling to do.

One of the things that many long-term investors like to do is to find companies with strong and lasting economic moats. The term “economic moat” was popularised by Warren Buffett and he uses it to refer to the characteristics a company has that protects its profits from competitors.

I recently published This is Berkshire Hathaway’s Simple But Unreplicable Competitive Advantage In The Insurance Industry. In it, I discussed the unique mindset that Buffett has that gives Berkshire (he’s the leader of the company) an unassailable edge over its insurance industry peers:

“What we’ve had going for us is a managerial mindset that most insurers find impossible to replicate.” This is the simple but unreplicable competitive advantage that Buffett and Berkshire has in the insurance industry. It is simple. You just have to be willing to tolerate a huge decline in business volume – potentially for a long time – if the pricing for business does not make sense. But it is unreplicable because it goes directly against our natural human tendency to be greedy for more.

If we spot similar simple but unreplicable competitive advantages in companies, it could lead us to fantastic long-term investment opportunities.“

After reading my article, a friend prompted me to also discuss Costco (NASDAQ: COST). The US-based warehouse retailer happens to also have a simple but unreplicable competitive advantage: A fanatical focus on lowering costs for customers, even at the expense of its short-term gain. Below are four few telling examples of the unique mindset that Costco’s leaders have

Uncommon

1. Inc. published an article in August 2019 about Costco and it said (emphases are mine):

“Unlike the typical 25 to 50 percent or more markups at most retailers, Costco caps its mark-ups at 14 percent for outside brands and 15 percent for Kirkland (in-house) brands.

But in many cases the markup is significantly lower, which is why the average mark-up across all Costco products is 11 percent.”

2. According to a June 2019 article from The Hustle (emphasis is mine):

“Not long ago, Costco was selling Calvin Klein jeans for $29 a pop — already $20 less than almost anywhere else — when a change in its purchasing deal meant Costco could get them for even less from the vendor. Instead of keeping the extra profit from the improved deal, it lowered the jeans’ price to $22.”

3. From the same article from The Hustle (emphases are mine):

“In the 2012 CNBC doc “Costco Craze,” a Costco buyer related one tale about a toy he found that retailed for $100. The company had the option of buying the unit for $50 wholesale and selling it for around $60 — but this wasn’t good enough.

Over a period of months, Costco ended up working with the vendor and its factory to redesign the toy from the ground up, analyzing every part of the process for ways to cut costs. In the end, Costco got the vendor to reduce the price by 50%, and sold it for $30.

The profit margin Costco made from the toy at $30 was the same it would’ve made at $60: The time and resources the company invested to lower the price were strictly for the benefit of their shoppers.”

4. Here’s an excerpt from a 2007 Wall Street Journal article (emphasis is mine):

“When the company signed a new contract in 2005 with a supplier for Brooks Brothers-style men’s cotton, button-down shirts, and got a significant price reduction for a massive two-year order, it immediately cut the price of the shirts to $12.99 from $17.99, notes Richard Galanti, Costco’s chief financial officer. Other retailers might have phased in the reduction and captured added profits, but that’s not the Costco way. The shirts now cost $14.99 because they are made with better-quality cotton.”

A market beater

So Costco has been relentless at lowering costs for its customers, often at the expense of its own short-term benefit. How has Costco’s business and share price done over time? Here’s a chart showing the growth in the company’s share price, earnings per share (EPS), and revenue since the start of 2007 – I chose 2007 as the start to remove the “rebound-effects” from the bottom of the Great Financial Crisis of 08/09.

Turns out, there has been solid growth in all three metrics! Costco’s management could have easily juiced the company’s revenues in the short run. But they held off, thinking that the long-term gains are even better. They have been right.

The table below shows Costco’s revenue and EPS from its fiscal year ended August (FY2007) to FY2019. It also shows the same numbers for Walmart (NYSE: WMT) over roughly the same period – for Walmart, it is the fiscal year ended January 2008 (WFY2008) to WFY2020. It’s definitely not an apples-to-apples comparison, but I think it’s instructive to compare Costco’s results with those of Walmart. That’s because Walmart is also a US-based bricks-and-mortar retailer – and one of the largest retailers in the world.

Costco has grown at a much faster pace than Walmart over a similar time period. Again, it’s not apples-to-apples. Walmart is much bigger than Costco, and size does create a drag on growth. But I can’t help but think that Costco’s faster growth over Walmart – in the face of the rise of online retail too, I need to add – is partly a result of the unique mindset that its leaders have.

A simple secret

In This is Berkshire Hathaway’s Simple But Unreplicable Competitive Advantage In The Insurance Industry, I wrote:

“Competitive advantages need not be complex. They can be simple. And sometimes the really simple ones end up being the hardest, or impossible, to copy. And that’s a beautiful thing for long-term investors.”

I want to expand on that. Costco is an example of a simple secret to long-term investing: A lasting competitive advantage can come from simply doing what others are unable or unwilling to do. Costco is willing to voluntarily lower the prices of its products to give customers the best deals. And it does this consistently. How many retailers are willing to do what Costco does? Not many, is my guess. And this is what gives Costco a lasting competitive advantage.

Why I Own Chipotle Mexican Grill Shares

My family’s investment portfolio has held Chipotle shares for many years and it has done well for us. Here’s why we continue to invest in Chipotle shares.

Chipotle Mexican Grill (NYSE: CMG) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Chipotle (pronounced “chi-POAT-lay”) shares for the portfolio in April 2012 at a price of US$265 and subsequently made five more purchases (in April 2015 at US$649; in November 2015 at US$605; in June 2016 at US$396; and twice in August 2017 at US$307 and US$311). I’ve not sold any of the shares I’ve bought.

Four of the six purchases have worked out very well for my family’s portfolio, with Chipotle’s share price being around US$882 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to hold Chipotle shares.

Company description

Chipotle’s business is simple. It runs fast-casual restaurants mainly in the US. Its namesake restaurants serve Mexican food – think burritos, burrito bowls (a burrito without the tortilla), tacos, and salads. A fast-casual restaurant is one with food quality that’s similar to full-service restaurants, but with the speed and convenience of fast food.

At the end of 2019, Chipotle had 2,580 namesake restaurants in the US and 39 namesake restaurants in other countries. The company also operated three restaurants in the US that are not under the Chipotle brand. That’s it for Chipotle’s business… on the surface.

Investment thesis

I had previously laid out my six-criteria investment framework in The Good Investors. I will use the same framework to describe my investment thesis for Chipotle.

1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market

In 2019, Chipotle raked in US$5.6 billion in revenue with its 2,622 restaurants. That sounds like Chipotle’s business is already massive. But it really isn’t. For perspective:

Number of Subway restaurants in the US in 2018, according to Satista: 24,798
Number of McDonald’s restaurants in the US currently: 14,428
Total retail sales of restaurants and other eating places in the US in 2019 according to data from the St Louis Federal Reserve: US$670 billion

These numbers show that Chipotle still has plenty of runway to grow.

2. A strong balance sheet with minimal or a reasonable amount of debt

As of 31 March 2020, Chipotle held zero debt and US$881.3 million in cash and investments. This is a rock solid balance sheet.

For the sake of conservatism, I note that Chipotle also had US$2.9 billion in operating lease liabilities. Given the ongoing restrictions on human movement in the US because of the country’s battle against COVID-19, restaurants in general are operating in a really tough environment. The good thing for Chipotle is that 94% of its total operating lease liabilities of US$2.9 billion are long-term in nature, with payment typically due only from 31 March 2021 onwards.

3. A management team with integrity, capability, and an innovative mindset

On integrity

Chipotle’s CEO is currently Brian Niccol, 46. Niccol joined Chipotle as CEO in March 2018 and was previously running the show at fast food chain Taco Bell. I appreciate Niccol’s relatively young age. The other important leaders in Chipotle, most of whom have relatively young ages (a good thing in my eyes), include:

In 2019, Niccol’s total compensation (excluding US$2.3 million of compensation for legal and tax fees that are related to his initial employment by Chipotle) was US$13.6 million. That’s a tidy sum of money. But of that, 62% came from stock awards and stock options. The stock awards are based on (1) the three-year growth in Chipotle’s comparable restaurant sales, which represents the year-on-year change in the revenue from Chipotle’s existing restaurants; and (2) the three-year average cash flow margin – cash flow as a percentage of revenue – for Chipotle’s restaurants. Meanwhile, the stock options vest over three years. These mean that the majority of Niccol’s compensation in 2019 depended on multi-year changes in Chipotle’s stock price and important financial metrics. I thus think that Niccol’s compensation structure is sensible and aligns his interests with mine as a shareholder of the company.

I want to highlight too that the other leaders of Chipotle that I mentioned earlier have similar remuneration plans as Niccol. In 2019, they received 69% of each of their compensation for the year in the form of stock awards and stock options with the same characteristics as Niccol’s.

On capability and innovation

There are a few key numbers that can tell us how well-run a restaurant company is: (1) Same store sales growth, and (2) average restaurant sales. The latter is self-explanatory but some of you may not be familiar with the former. Same store sales growth typically represents the change in period-over-period revenue for a company’s restaurants that are in operation for 12 months or more (it’s 13 months in the case of Chipotle). So what same store sales growth measures is essentially the growth in revenue for a restaurant company from its existing stores. The table below shows Chipotle’s same store sales growth and average restaurant sales from 2004 to 2019:

You can see that the company fared really well on both fronts until 2015, when there were some struggles for a few years before growth started resuming in 2017. When discussing Chipotle’s management, I want to break up the story into two portions. The first stretches from Chipotle’s founding to 2015, while the second is from 2015 to today.

First portion of the story

Chipotle was founded by classically-trained chef Steve Ells in 1993. He served as the company’s CEO from its founding to early 2018. Ells created the company’s first restaurant with what I think is a pretty simple but radical idea. According to the first page of Chipotle’s IPO prospectus, Ells wanted to “demonstrate that food served fast didn’t have to be a “fast-food” experience.” The first page of the prospectus continued:

“We use high-quality raw ingredients, classic cooking methods and a distinctive interior design, and have friendly people to take care of each customer — features that are more frequently found in the world of fine dining.”

Ells never floundered on his initial vision for serving great food, not even when Chipotle was owned by – you’ll never guess it – McDonald’s. All told, Chipotle was under McDonald’s for eight years from 1998 to 2006. McDonald’s gave Chipotle the operational knowledge needed to scale from 13 restaurants to almost 500. But Ells frequently clashed with McDonald’s management over cultural differences. Here are two quotes from a brilliant Bloomberg profile of Chipotle’s entire history from 1993 to 2014 that describes the differences:

1. “What we found at the end of the day was that culturally we’re very different. There are two big things that we do differently. One is the way we approach food, and the other is the way we approach our people culture. It’s the combination of those things that I think make us successful.”

2. “Our food cost is what runs in a very upscale restaurant, which was really hard for McDonald’s. They’d say, “Gosh guys, why are you running 30 percent to 32 percent food costs? That’s ridiculous; that’s like a steakhouse.””

Nonetheless, Chipotle became a fast-growing restaurant company under McDonald’s. Its success even spawned the “fast-casual” category of restaurants in the US. For a feel of what fast-casual means, the closest example I can think of in Singapore will be the Shake Shack burger restaurants here. The food is of much better quality than traditional fast food and the price point is a little higher, but the serving format is quick and casual.

After leaving McDonald’s umbrella via an IPO in January 2006, Chipotle continued to succeed for many years. As I mentioned earlier, Chipotle enjoyed strong growth in same store sales and average restaurant sales from 2004 to 2015. A beautiful example of Chipotle’s relative success over McDonald’s can be found in the Bloomberg profile. There’s a chart showing Chipotle’s much higher same-store sales growth from 2006 to the third-quarter of 2014:

To me, one of the key reasons behind Chipotle’s growth was its unique food culture. The company calls this “Food with Integrity.” Here’s how Chipotle described its food mantra in its IPO prospectus:

“Our focus has always been on using the kinds of higher-quality ingredients and cooking techniques used in high-end restaurants to make great food accessible at reasonable prices.

But our vision has evolved. While using a variety of fresh ingredients remains the foundation of our menu, we believe that “fresh is not enough, anymore.” Now we want to know where all of our ingredients come from, so that we can be sure they are as flavorful as possible while understanding the environmental and societal impact of our business. We call this idea “food with integrity,” and it guides how we run our business.”

This is how Chipotle discussed “Food with Integrity” in its annual report for 2015; the focus on serving tasty, fresh, sustainably-produced food still remained in 2015:

“Serving high quality food while still charging reasonable prices is critical to our vision to change the way people think about and eat fast food. As part of our Food With Integrity philosophy, we believe that purchasing fresh ingredients is not enough, so we spend time on farms and in the field to understand where our food comes from and how it is raised. Because our menu is so focused, we can concentrate on the sources of each ingredient, and this has become a cornerstone of our continuous effort to improve our food.”

Another key contributor to Chipotle’s strong restaurant performance, in my opinion, is its Restaurateur program. The program, which started in 2005, is meant to improve employee-performance at each restaurant while providing excellent career prospects. Here’s a description of it from a 2014 Quartz article:

“During a busy lunch rush at a typical Chipotle restaurant, there are 20 steaks on the grill, and workers preparing massive batches of guacamole and seamlessly swapping out pans of ingredients. Compared to most fast-food chains, Chipotle favors human skill over rules, robots, and timers. Every employee can work in the kitchen and is expected to adjust the guacamole recipe if a crate of jalapeños is particularly hot.

So how did the Mexican-style food chain come to be like this while expanding massively since the 2000s?

In 2005, the US company underwent a transformation that would make its culture as distinct as its food. As more than 1,000 stores opened across the US, the company focused on creating a system where promoting managers from within would create a feedback loop of better, more motivated employees. That year, about 20% of the company’s managers had been promoted from within. Last year, nearly 86% of salaried managers and 96% of hourly managers were the result of internal promotions.

Fundamental to this transformation is something Chipotle calls the restaurateur program, which allows hourly crew members to become managers earning well over [US]$100,000 a year. Restaurateurs are chosen from the ranks of general managers for their skill at managing their restaurant and, especially, their staff. When selected, they get a one-time bonus and stock options. And after that they receive an extra [US]$10,000 each time they train a crew member to become a general manager.”

The Restaurateur program was the brainchild of Monty Moran. Moran joined Chipotle as COO (Chief Operating Officer) in March 2005 and became Co-CEO with Ells in January 2009. Moran stepped down from his position as Co-CEO in late 2016.

Second portion of the story

2015 was a turning point for Chipotle. In the second half of the year, a food-safety crisis erupted. Around 500 people became ill from E.Coli, salmonella, and norovirus after eating at the company’s restaurants. This badly affected consumer confidence at Chipotle, which manifested in the sharp declines in the company’s same store sales growth and average restaurant sales in 2016.

What were initially strengths – Chipotle’s food and people culture – ended up causing problems for the company. “Food with Integrity” meant that every restaurant used a lot of raw food ingredients and had to do a lot of food preparation within its own four walls; the company’s people culture involved measuring performance based on a restaurant’s throughput (or how fast it can take an order, make the order, and serve it). These two things combined meant that food safety could at times be compromised.

After the late-2015 food safety issue flared up, Ells and his team embarked on fixing the issues at the company. But they struggled, and 2016 became a painful year for Chipotle. Monty Moran left as Co-CEO in late December 2016; around a year later, Ells stepped down from his CEO position and assumed the role of executive chairman. Ells left Chipotle completely in March this year. Brian Niccol, who already had leadership experience at a fast food chain (Taco Bell), succeeded Ells as CEO in March 2018.

When Niccol first came onboard, I remember being worried. I was concerned that he would dilute Chipotle’s food and people culture by introducing a more sterile way of doing business, such as the methods found in traditional fast food chains. But Niccol and his team have managed to retain what is special about Chipotle while improving the areas that needed fixing.

In Chipotle’s latest annual report (for 2019), the company still placed an emphasis on “Food with Integrity”:

“Serving high quality food while still charging reasonable prices is critical to ensuring guests enjoy wholesome food at a great value. We respect our environment and insist on preparing, cooking, and serving nutritious food made from natural ingredients and animals that are raised or grown with care. We spend time on farms and in the field to understand where our food comes from and how it is raised. We concentrate on the sourcing of each ingredient, and this has become a cornerstone of our continuous effort to improve the food we serve. Our food is made from ingredients that everyone can both recognize and pronounce.

We’re all about simple, fresh food without the use of artificial colors or flavors typically found in fast food—just genuine real ingredients and their individual, delectable flavors.”

The Restaurateur program still exists, but there is a more holistic framework at Chipotle for evaluating and improving employee performance compared to the past.

Niccol and his team have also directed Chipotle to invest heavily in digital and other initiatives, such as: Digital/mobile ordering platforms; digital pick-up shelves; digital order pick-up drive-through lanes that are cutely named “Chipotlanes”; delivery and catering; and a rewards program. These investments have seen massive success. Here are some data points:

In 2017 Chipotle started upgrading second-make lines in its restaurants to specifically handle digital and delivery orders, so as not to disrupt the company’s in-restaurant food preparation procedures; the company ended 2019 with nearly all restaurants having these upgraded second-make lines.
2019 also saw Chipotle complete the rollout of digital pick-up shelves across all its restaurants, and expand delivery capabilities to over 98% of its store base.
In 2018 digital and delivery sales grew by 43% and accounted for 10.9% of Chipotle’s overall revenue; in 2019, digital and delivery sales surged by 90% and accounted for 18.0% of total revenue; in the first quarter of 2020, digital and delivery sales were up 81% and were 26.3% of total revenue; digital and delivery sales were in the “high 60s” percentage range of total revenue for the month of April so far.
Chipotle introduced a rewards program in March 2019 that kicked off with 3 million members. At end-2019, there were 8.5 million members; in the first quarter of 2020, the member count has jumped to 11.5 million.
Chipotle enjoyed a strong uptick in same store sales growth and average restaurant sales in 2019; in the first two months of 2020, same store sales growth was a sensational 14.4%.

The work isn’t done. Chipotle’s restaurant-level operating margin was 20.5% in 2019, up from 18.7% in 2018 but a far cry from the high-20s range the company was famous for prior to its late-2015 food safety issue. But in all, I give Niccol an A-plus for his time at Chipotle so far. He has only been at the company for a relatively short while, but the transformation has been impressive.

4. Revenue streams that are recurring in nature, either through contracts or customer-behaviour

I think it’s sensible to conclude that restaurant companies such as Chipotle enjoy recurring revenues simply due to the nature of their business: Customers keep coming back to buy food.

5. A proven ability to grow

The table below shows Chipotle’s important financials from 2005 to 2019:

A few key points about Chipotle’s financials:

Revenue compounded at an impressive rate of 21.8% from 2005 to 2015. Net profit stepped up at an even faster pace of 28.9% per year over the same period. Operating cash flow was consistently positively from 2005 to 2015 and compounded at a similarly strong annual rate of 24.3%. Free cash flow was positive in every year from 2006 to 2015, and became strong from 2008 onwards.
2016 was a year where Chipotle reset its business after it suffered from food safety issues, as mentioned earlier. Some of the 2019 numbers for Chipotle are still lower than in 2015. But it’s worth noting that net profit, operating cash flow, and free cash flow compounded at 40.9%, 24.1%, and 24.2%, respectively, from 2017 to 2019. It’s also a positive, in my eyes, that Chipotle managed to produce solidly positive operating cash flow and free cash flow in 2016, at the height of its struggles with the food safety problems.
Chipotle’s balance sheet was rock-solid for the entire time period I’m looking at, with debt being zero all the way. This is made even more impressive when I consider the fact that the company had expanded its restaurant count significantly from 2005 to 2019 (see table below). I salute a restaurant company when it is able to grow without taking on any debt.
Dilution has not happened at Chipotle, since its diluted shares outstanding has actually declined from 2006 to 2019.

In the first quarter of 2020, Chipotle’s business encountered some speed bumps through no fault of its own. The US has been hit hard by the ongoing pandemic, COVID-19, with most states in the country currently in some form of lockdown. The lockdowns have understandably affected Chipotle’s business, but the company is handling the crisis well, even though there will be pain in the coming quarters. Here are some data I picked up from the company’s latest earnings update and earnings conference call (I had already discussed some of them earlier in this article):

Revenue increased 7.8% year-on-year to US$1.4 billion in the first quarter of 2020.
The balance sheet remains robust with zero debt and US$881.3 million in cash and investments as of 31 March 2020.
Chipotle was still profitable in the first quarter of 2020, with profit of US$76.4 million, down 13.3% year-on-year.
Operating cash flow for the first quarter of 2020 was unchanged from a year ago at US$182.1 million; free cash flow was down 12% to US$104.4 million.
Same store sales in the first two months of 2020 were up 14.4%. In March, it was down by 16%, with the week ending March 29 being the worst with a decline of 35%. April’s same store sales for the most recent week was in the “negative high-teens range.”
Digital and delivery sales were up 103% year-on-year in March to account for 37.6% of Chipotle’s total revenue; in April, digital and delivery sales were nearly 70% of total revenue. Digital sales have traditionally been stickier for Chipotle.
The company is continuing to reward its employees: (1) Employees who were willing and able to work between 16 March and 10 May were given a 10% increase in hourly rates; (2) a discretionary bonus of nearly US$7 million for the first quarter of 2020 was given to field leaders, general managers, apprentices, and eligible hourly employees; (3) US$2 million in assistance bonuses have been made available for general managers and their apprentices for their services in April; and (4) Emergency lead benefits were expanded to accommodate those directly affected by COVID-19.
Chipotle is continuing to develop new restaurant units (although there are construction-related delays) and the availability of sites have increased as other businesses have pulled back spending.
Chipotle’s rewards program has increased from 8.5 million members at end-2019 to 11.5 million in the first quarter of 2020; daily signups to the rewards program have also spiked by nearly four fold in the last month.
In the first quarter of 2020, Chipotle opened 19 restaurants, of which 11 have a Chipotlane, the company’s digital-order pick-up drive-through lane. Even before COVID-19 struck, stores with Chipotlanes had opening sales that were 5% to 10% higher than those without Chipotlanes; now, the outperformance has reached over 30%. What’s more, stores with Chipotlanes have a digital mix of nearly 80%; the mix of “higher margin order-ahead and pick-up transactions has more than doubled” for Chipotlane restaurants compared to pre-COVID times. As a result of the continued strong performance at restaurants with a Chipotlane, and lesser competition for new sites, restaurants with a Chipotlane will comprise an even greater proportion of Chipotle’s future restaurant openings.
Assuming a same store sales decline of 30% to 35%, Chipotle’s balance sheet can sustain the company for “well over a year.” It’s worth noting that Chipotle’s same store sales has increased to the negative high-teens range in April. The company still has room to make additional adjustments to reduce expenses if the recovery from COVID-19 takes longer than expected.

6. A high likelihood of generating a strong and growing stream of free cash flow in the future

There are two reasons why I think Chipotle excels in this criterion.

Firstly, the restaurant operator has done very well in producing free cash flow from its business for a long time. It even managed to produce a solid stream of free cash flow in 2016, when it was mired in its food safety crisis.

Secondly, there’s still tremendous room to grow for Chipotle. Yes, there’s plenty of short-term uncertainty now because of the COVID-19 pandemic. But when it clears, customers should still continue to flock to the company’s restaurants. Chipotle is nowhere near saturation point when it comes to its restaurant-count, and the US restaurant market is significantly larger than the company’s revenue. I want to repeat that digital sales have traditionally been sticky for Chipotle. So the current surge in digital sales for the company during this COVID-19 period could become a strong foundation for Chipotle’s future growth when the pandemic eventually clears.

Valuation

I like to keep things simple in the valuation process. In the case of Chipotle, I think the price-to-free cash flow (P/FCF) ratio is an appropriate measure for its value. The company operates restaurants, which is a cash-generative business, and it has been adept at producing free cash flow over time.

On a trailing basis, Chipotle has a trailing P/FCF ratio of around 67 at a share price of US$882. There’s no way to sugar-coat this, but Chipotle’s P/FCF ratio is high. The chart below shows Chipotle’s historical P/FCF ratio over the past 10 years:

We can see that Chipotle’s current P/FCF ratio is also high when compared to history. The next few quarters will be a massive test for the company. But Chipotle is well-positioned to survive the COVID-19 crisis as I discussed earlier. It is also putting in place the building blocks for future growth – such as well-designed drive-through lanes and digital/mobile ordering platforms – once the ongoing health crisis becomes a memory. So I’m still comfortable staying invested with Chipotle despite the seemingly high P/FCF ratio, which should become even higher over the next few quarters as the company’s free cash flow falls, temporarily.

The risks involved

The biggest risk confronting Chipotle at the moment has to be the economic slowdown and restrictions on human movement in the US that have appeared because of COVID-19. But I also discussed earlier in this article how Chipotle is faring relatively well during the pandemic. Nonetheless, I’m still keeping an eye on things here.

Another big risk affecting Chipotle is food safety. Chipotle was well on its way to recovering from its food safety issue that flared up in late 2015 before COVID-19 struck. The company has dramatically improved its food safety measures compared to in 2015, but I don’t think it’s possible to completely eliminate the chances of food safety problems appearing again in the future. If Chipotle is unfortunate to have to deal with another food safety problem during this ongoing COVID-19 pandemic, its reputation with consumers could be dealt a crippling blow.

The last big risk I’m watching are changes to Chipotle’s food and people culture. CEO Brian Niccol has done a great job in improving Chipotle’s business operations while retaining the things that make Chipotle special. But if Chipotle’s food and people culture were to change in the future, I will be watching the developments. I think that Chipotle’s food and people culture have been tremendous drivers of the company’s growth, so I want to keep track of changes in these areas.

My conclusion

Chipotle’s a fast-casual restaurant company with a unique people and food culture. From its founding in 1993 to 2015, it managed to grow tremendously under the watch of founder Steve Ells – and it grew without using debt, which is a mightily impressive feat. Food safety issues erupted in late 2015, which caused setbacks for Chipotle. But new CEO Brian Niccol came in and made significant positive changes at the company. Chipotle was well on its way to recovery when COVID-19 struck. Thankfully, the changes that Niccol has implemented, such as the digital investments, have served Chipotle well. The company looks well positioned to survive the current COVID-19 crisis, and changes to consumer behaviour in the current environment also appear to be building a solid foundation for Chipotle’s future growth when the crisis ends.

There are risks to note of course. A prolonged recovery from COVID-19 could hurt Chipotle’s business near-permanently. The occurrence of another food safety issue during COVID-19 will also be disastrous for the company. But after weighing the pros and cons, I’m happy to continue owning Chipotle shares.

And now it’s time for me to find some delivery or takeaway for great Mexican fare for lunch…

Webinar: “Finding Long-Term Investment Opportunities During The Current COVID-19 Crisis”

A webinar on how investors can exhibit good investing behaviour and find investment opportunities in the current COVID-19 crisis.

On 23 April 2020, Jeremy and I presented at a webinar organised by Online Traders’ Club. We want to thank the Online Traders’ Club for taking charge of all the logistics brilliantly. The title of the webinar is given in the title of this article.

I promised during the webinar that we will be sharing the session and the presentation deck on The Good Investors. Here it is!

Jeremy and I want to share the webinar freely because we think it contains important information that can help guide investors toward better investing behaviour. This is very important in the economically-stressful environment Singapore and the rest of the world is in today. Many thanks to Online Traders’ Club for publishing the webinar on Youtube so that the public can access it!

Webinar recording and deck

You can download the presentation deck here

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

What We’re Reading (Week Ending 26 April 2020)

The best articles we’ve read in recent times on a wide range of topics, including investing, business, and the world in general.

We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!

Here are the articles for the week ending 26 April 2020:

1. The first modern pandemic – Bill Gates

Melinda and I grew up learning that World War II was the defining moment of our parents’ generation. In a similar way, the COVID-19 pandemic—the first modern pandemic—will define this era. No one who lives through Pandemic I will ever forget it. And it is impossible to overstate the pain that people are feeling now and will continue to feel for years to come.

The heavy cost of the pandemic for lower-paid and poor people is a special concern for Melinda and me. The disease is disproportionately hurting poorer communities and racial minorities. Likewise, the economic impact of the shutdown is hitting low-income, minority workers the hardest. Policymakers will need to make sure that, as the country opens up, the recovery doesn’t make inequality even worse than it already is.

At the same time, we are impressed with how the world is coming together to fight this fight. Every day, we talk to scientists at universities and small companies, CEOs of pharmaceutical companies, or heads of government to make sure that the new tools I’ve discussed become available as soon as possible. And there are so many heroes to admire right now, including the health workers on the front line. When the world eventually declares Pandemic I over, we will have all of them to thank for it.

2. Charlie Munger, Unplugged – Jason Zweig and Nicole Friedman

If I have to be a little bit more cheerful about things, then I say to myself, ‘I’m lying, but I’m going to do it anyway.’ [Pause.] I had a son [Teddy] who died [of leukemia in 1955]. I told him he wasn’t going to die. When he started his thing, I lied. It just killed me, but I just lied to him. [Long pause.] He was 9 years old. [Extended pause.] I’m sure I did the right thing, but it hurts. [Clears his throat.]

3. It’s Time To Build – Marc Andreessen

You see it in housing and the physical footprint of our cities. We can’t build nearly enough housing in our cities with surging economic potential — which results in crazily skyrocketing housing prices in places like San Francisco, making it nearly impossible for regular people to move in and take the jobs of the future. We also can’t build the cities themselves anymore. When the producers of HBO’s “Westworld” wanted to portray the American city of the future, they didn’t film in Seattle or Los Angeles or Austin — they went to Singapore. We should have gleaming skyscrapers and spectacular living environments in all our best cities at levels way beyond what we have now; where are they?

You see it in education. We have top-end universities, yes, but with the capacity to teach only a microscopic percentage of the 4 million new 18 year olds in the U.S. each year, or the 120 million new 18 year olds in the world each year. Why not educate every 18 year old? Isn’t that the most important thing we can possibly do? Why not build a far larger number of universities, or scale the ones we have way up? The last major innovation in K-12 education was Montessori, which traces back to the 1960s; we’ve been doing education research that’s never reached practical deployment for 50 years since; why not build a lot more great K-12 schools using everything we now know? We know one-to-one tutoring can reliably increase education outcomes by two standard deviations (the Bloom two-sigma effect); we have the internet; why haven’t we built systems to match every young learner with an older tutor to dramatically improve student success?

4. What’s Different This Time – Morgan Housel

We are medically more prepared to fight disease than ever before. But, psychologically, the mere thought of a pandemic has never felt so foreign, so unprecedented. What was a tragic but expected part of life 100 years ago is now a tragic and inconceivable part of life in 2020.

Compared with other pandemics even as recent as the 1960s, it’s different this time because so few people today had the slightest expectation that an infectious disease would ever impact their lives. Even if covid-19 ends up medically less impactful than what happened in 1957 or 1968, the shock and surprise effect may be greater.

My Quick Thoughts On Oil Falling To A Negative Price

With oil falling to a negative price, investors may be tempted to invest in oil & gas stocks such as Sembcorp Marine. But there are important risks to note.

I’m writing this article on the morning of 21 April 2020 (Tuesday) in Singapore. On the night of 20 April 2020, the price of oil fell to negative territory. I’m referring specifically to contracts for deliveries of West Texas Intermediate (WTI) crude oil in early May.

Here are some quick thoughts I have on this development…

1. Scott Sagan, a professor of political science, once wrote that “things that have never happened before, happen all the time in history.” Last night was the first time ever that oil prices became negative. Historic and fascinating? Yes. Surprising? It shouldn’t be. Crazy things happen all the time in the world of finance.

2. I hope investors are not lured to invest in oil & gas stocks simply because the price of oil is now so low. There are two important things to note:

Predicting the future of oil prices is practically impossible. In 2007, Peter Davies gave a presentation titled What’s the Value of an Energy Economist? He said in the presentation that “we cannot forecast oil prices with any degree of accuracy over any period whether short or long.” Back then, Davies was the chief economist of British Petroleum (LSE: BP), one of the largest oil & gas companies in the world.
Oil & gas stocks need not follow the movement of oil prices. In mid-2014, oil prices started falling from around US$100 per barrel. WTI reached a low of US$26.61 in February 2016 before doubling to US$53.53 just 10 months later (on 21 December 2016). I tracked the share prices of a group of 50 oil & gas stocks in Singapore’s stock market and found that over the same period, 34 of them saw their share prices fall. The average decline for all the 50 companies was 11.9%.

3. Investing in an oil & gas stock also means the need to study its financials and – especially in today’s climate – its balance sheet. Even before the historic slump in oil prices on Monday night, there have already been oil & gas companies in the US effectively going bankrupt (see here and here). And speaking of financial trouble…

4. I fear for Singapore’s oil & gas giant Sembcorp Marine (SGX: S51). As of 31 December 2019, Sembcorp Marine, which builds oil rigs and other types of vessels, had S$389 million in cash but S$1.4 billion in short-term debt and S$3.0 billion in long-term debt. The company had S$2.9 billion in short-term liabilities but just S$2.5 billion in short-term assets. Of the short-term assets, only S$389 million is in cash; the bulk of it are in “contract assets” worth S$1.5 billion. Unfortunately, “contract assets” consist of recognised revenue for ongoing projects and don’t represent real cash until the projects are delivered. In crisis situations – and we are in a crisis situation – all liabilities become real and most assets except cash have to be heavily discounted.

5. Given the rapid deterioration in global economic conditions since end-2019, it’s likely that Sembcorp Marine’s financial health has weakened significantly from an already poor condition from what I just described in Point Four. The good thing is that Sembcorp Marine’s majority shareholder is Sembcorp Industries (SGX: U96), which is controlled by Temasek Holdings, one of the Singapore government’s investment arms. So it’s likely that financial support for Sembcorp Marine will be strong, if push comes to shove. That said, financial support for Sembcorp Marine does not necessarily mean that its shareholders will end up fine on the other side of this crisis.

6. I’ve stopped having an interest in investing in oil & gas companies for many years because I know my limitations. Investing in oil & gas companies, in my opinion, requires skills that I don’t – and will never – have. I just hope that investors who are tempted to invest in oil & gas stocks because of the historical fall in oil prices on Monday night are fully aware of the risks involved and go in with their eyes wide open.