Barton Biggs on Controlling Investment-Related Costs
The following is an excerpt from Morgan Stanley Dean Witter’s Strategy and Economics, by Barton Biggs, 11/30/1998, reproduced here with Mr. Biggs’ permission.
Charles Munger says ...
I don’t know Charlie Munger, Warren Buffett’s partner at Berkshire Hathaway, but he must be a smart, brave guy. On October 14 he gave a great speech to a meeting of foundation financial officers that took hard, reasoned shots at many of the deeply revered practices and received wisdom of institutional investment management.Munger thinks "the layers of complexity" that most institutions have put in place to manage their money are a "waste." These institutions have become "funds of funds, and he severely questions the value and impartiality of consultants who pick consultants, the multiple investment management firms, and "the biased" security analysts who work for investment banks. He estimates that the total "croupiers’ take" of this group is at least 3% per annum.
This number sounds high to me, as most large pension funds have total management and supervision costs of 30-40 basis points, but this does not include trading and research expenses. Costs for a medium-sized foundation with one billion dollars might be about 65 basis points (excluding trading and research).
Munger says this "croupiers’ cost," this "performance disadvantage" is one thing when equities are compounding at 17% a year as they have been, but quite another if "over some long future period" returns go back to 5%. Then the average foundation which has to give away 5% of its assets each year will have an annual shrinkage of 3% (+5%–3%–5%= -3%). He doesn’t mention it, but the same calculus applies to pension funds with high return assumptions and to mutual funds.
Munger then remarks that indexing is one way to reduce this cost and is a wiser choice than what most institutions are doing now. I assume that when he talks of indexing he means it as a way of life in which small- and medium-capitalization stock indexes would be used as well as the S&P 500 index.
I agree up to a point, because the record is clear that active large-cap managers as a group do not outperform the S&P 500 over the long run, and this is particularly the case when returns from large-cap stocks are very high as they have been recently. Large-cap managers are more likely to outperform when returns are low or negative because cash and market timing then become more important. Every institution with several billion dollars in equities should have a portion of it indexed, in my opinion, but after seven fat years now may not be the time to do it.
Munger is also leery of LBO funds. "Buying 100% of corporations with much financial leverage and two layers of promotional carry (one for the management and one for the general partners in the LBO fund) is no sure thing to outperform equity indexes in the future, "he says, "particularly if equity indexes perform poorly" or if general business conditions are difficult.
Furthermore, there is increasing competition for LBO deals, which means higher entry prices. There are a large number of LBO funds awash with money and with general partners highly incentivized and therefore itching to buy something. Munger specifically mentions GE Credit, which can finance at an interest rate only slightly higher than Treasuries, as "super-competition." He concludes: "In short, in the LBO field there is a buried covariance with marketable equities — towards disaster in generally bad business conditions — and competition is now extreme."
Munger also thinks the general view that diversification is a must is "grossly mistaken." He argues that an individual or institution that owns "three fine domestic corporations is securely rich." A fiduciary should consider "long-term investment concentration in a few domestic companies that are widely admired."
This approach, he says, results in lower costs, emphasis on long-term effects, and concentration on the few best stocks. He even says that it can be rational for a family or foundation to remain 90% in one equity if it is convinced that the future of that company is good.
This is a version of the old "put all your eggs in one basket and then watch that basket like a maniac." It is fine for Munger to say this, with the record he has had, but other fiduciaries may not have such impeccable taste (or good fortune) in stock selection. Companies that are "widely admired" generally have stocks whose price reflects that admiration. And just for the record, the first tenet of fiduciary responsibility is diversification.
Munger thinks international diversification is another expensive complexity that should be dispensed with. The U.S. cultural and legal system is the best in the world, he argues, and far more friendly to shareholder interests than any other country’s. In fact, in some countries public shareholders, particularly foreign ones, have very little standing. "I tend to prefer, over direct foreign investment, Berkshire’s practice of participating in foreign economies through the likes of Coca-Cola and Gillette."
He may be right, but Coke ($72) and Gillette ($46) are very expensive, and there are non-U.S. companies which are either already great or are becoming great that are considerably cheaper than the names Berkshire has in its portfolio. I think Munger is silly to exclude 60% of the stocks in the world from his universe just because they are outside the U.S. and riskier.
The big U.S. blue chips are great companies and have been great stocks, but they are very expensive. I would have thought a value investor like Munger would be searching the world, not just America, for great franchises at reasonable valuations. However, he is right that for a U.S. institution, investing internationally adds another layer of consultants and complexity.
I know that Buffet himself agrees, because I once asked him why he didn’t invest in emerging market equities. His answer was that he got all the emerging markets’ play he wanted from Coke. It certainly was a wise answer in view of the shellacking emerging-market equities have taken in the last year. However, in my opinion, emerging markets will have their best time in the sun again, and owning the great multinationals will not be the best way to participate.
Munger also is not a fan of "fancy limited partnerships," modern portfolio theory, and quantitative analysis. He points out that sometimes "smart, hard-working people aren’t exempted from professional disasters from overconfidence. Often they just go around in more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods."
Furthermore, the complex, high-cost investment modalities becoming ever more popular at institutions contain "profoundly anti-social effects" because more of the nation’s best and the brightest "are attracted into lucrative money management and its attendant modern frictions [fictions?] as distinguished from work providing more value to others."
He is right.
It’s a great speech.