How I met Warren Buffett and what I learnt from him (Q&A session part II/II) and his management teams (Key lessons part I/II)

On February 17, 2017, thanks to the MBA selection of Guanghua School of Management, I had the chance to go to Omaha - accompanied with 19 other students of Guanghua, Peking University and our dear investment professor Jeffrey Towson - to meet Mr. Warren Buffett and visit three of his portfolio companies.

We had the chance to ask Mr. Buffett a few questions during the Q&A session and lunch time and interview his management teams during the company tours. Please find below the following part of our Q&A session with Mr. Buffett and some interesting facts about his portfolio companies.

Q&A session with Mr. Warren Buffett part II/II

Q1:What was your most difficult investment experience?

When I first started buying businesses, I started buying very cheap and not-so-good businesses. You can't fix bad businesses. And it's no fun. Berkshire Hathaway had 12,000 employees but only 3,000 when I bought it. And half of them spoke Portuguese. I took me 20 years to get out of it and the idea of “cigar butt” investing. Bad businesses are like a “leaking boat”. It is better to get into a new boat than to patch it.

Charlie told me to get great businesses. US Arrow Air Inc. (cargo airline) in 1987 was sold for more than $30 million, the company went bankrupt twice. In the world of investing, you shouldn’t worry too much about the mistakes.

Q2: You recently had a conversation with Bill Gates on AI. What is your opinion about AI’s influence on the investment industry and the stock market?

There is no question that AI is coming. AI is going to change some industries dramatically, but not investment. In 2013, I listened to some experts and I decided that it is still tough for AI to do some things. Investment is not only about calculation. In short-term trading, AI and computers can do the trades. But in long-term investing, AI is not changing the game much. It does not help you find investments.

Back in 1987, the stock market dropped 22% in one day. That was a computer breakdown. I will stay with my comments that the computer and AI will not change the investment sector too much.

Q3: Banking regulations: Banks want to deregulate, but how do you balance regulations of the industry with growth?

There is a great article addressing the questions you asked. It was written by Tim Geithner and published in October 16th.

Federal Deposit Insurance Corporation (FDIC) is a government corporation providing deposit insurance to depositors in US banks. When banks go broke, it is the taxpayers paying the expense. But this has never really happened. This is a good example of good regulation.

There is no question about banks needing to be regulated. When people are afraid, they run to the door. However, confidence comes back one at a time.

To some extent, we need to regulate for the worst-case scenario. We must bring in the FDIC to stabilize banking system. Our economy will not work without the Fed.

Q4: Question on leadership

When doing business, you should not say “everybody else is doing something so we should follow”. Consider what you really need and want to do. On being a successful leader, the basic job is to put the right person at the right place and monitor the whole business. Also, always do what you promise so that your employees will trust you.

Q5: Question about passive managed funds

It has been 9 years since I made a 1 million bet with Protégé Partners, LLC. It is the largest bet on the website Longbets.org.

Over a ten-year period, I predicted that the S&P 500 will outperform a portfolio of hedge funds, when performance is measured on a basis net of fees, costs, and expenses.

2008 was the first year and the market went down a lot. The fund of hedge funds performed better than the index.

9 years later, the fund of hedge funds, invested in 7200 hedge funds, has had a cumulative return of 22%. The index has yielded 86%. We are in a commanding 64% lead with one year to go.

Hedge funds get rich on fees. Wall Street sells you what you will buy. Hyper activity is bad, “fees never sleep”

Q6: The speed of information is faster and faster. There are fewer mispriced securities. How has this changed your investments?

It is true that the market today is a lot more competitive than 50 years ago. It is also true that information can be accessed faster and easier. When I was at school in 1957, I gained information from the annual report of companies. At that time, the annual reports and the Moody's and S&P manuals provided the key information on companies (Buffet brought a binder out). On page 1433, the book showed the financial report for the insurance company NWLI. In 1950, the company earned 21.66 dollars per share and this grew to 29.09 dollars per share one year after. But the share was selling 3.13 dollars per share. The company had a terribly small float, but I was as small investor at that time. It wasn't difficult to buy stocks at that time.

Years later, somebody told me that I should pay attention to the Korean market. I read a report from Citi where one stock was introduced on each page. You can get a lot of information from this. I found 15-20 stocks trading at about 2x earnings and bought them as a group. It took about three hours of work on a Sunday.

You don't need an information edge. You need a willingness to act.

Q7: If you graduated in 2016, what would be your initial step to build your career?

You need an audited record. Even if its tiny. Have 5 years of what you have done and how it was done. I selected two people to come into Berkshire, each now managing $10 billion. These two managers have qualities that are rare. They had track records.

Don't postpone things in life for money or career. After graduation, I would do what I would do if I didn’t need to have a job. Pretend you are rich. I don’t want to sleep walk to work. I would not worry about starting salary. I would do things that I really like in life. If not, I would end up looking at the clock after 3:00 and 3:10.

Q8: What are the top three challenges faced by boards of directors?

I think their primary job is to pick the right CEO and then to make sure he or she doesn't over-reach.

Also they face challenges in acquisitions. Usually, an acquisition is a one-sided presentation with CEOs presenting why and how the companies is going to benefit. I have witnessed over a hundred acquisition presentations and the majority were impossible to stop. I would suggest the system where one investment banker points out why the deal should be go through and another one points out why the deal should not go through. Only the winner gets paid. This would ensure the reasoning for acquisition would be evenhanded. Killing deals in unpleasant and you don't get invited back. Most CEOs know little about acquisitions but it is important for them to know it well.

Key takeaway lessons learnt from the company visits and the interactions with the staff (Part I/II)

Many thanks to the executives and the operational staff for answering all our questions with transparency and accuracy and sharing with us your insights. Now, we understand more how the "Louvre of Businesses" (Hi teacher Jeffrey) has been constituted and most of all, what are some key competitive advantages of Warren Buffett's companies.

Nebraska Furniture Mart (a.k.a "NFM"): a local leader in home furnishing solutions with immense barriers to entry for its competitors

• Size matters. With an 80-acre store integrated with big warehouses and the headquarters on top of the store, NFM has managed to optimize its supply chain and its inventory to a level almost unbeatable for its competitors. By reinvesting all the profits in constituting a wide and diverse inventory of products located next to the store and displaying all these physical products together, they enable the consumers to compare, test and acquire products in a very efficient way. As fixed costs grow over time, it is more difficult for competitors to enter the market.
• Location, location, location. With a location in a suburbian area of Omaha, NFM manages to obtain lower rent costs than in the city centre. It gives NFM more space to store, display and deliver its products and more space to welcome its customers. Location and real estate governance are therefore key elements contributing to NFM's success.
• Keep your friends close and your enemies even closer. Every single business day, NFM adjusts the prices of its home appliances (electronics, kitchenware, etc.) products to be cheaper than all the prices offered by its competitors. Thanks to LED price tags monitored by bots and algorithms comparing the prices of each product between NFM and the competitors online, it will update all the price tags every morning to be cheaper than everyone else including Amazon for instance.
• Forecast, plan (or follow) the social media trends. When Facebook Live kicked off in the USA, NFM did a live streaming visit of its store with a famous social media influencer. As the Internet celebrity was playing randomly with one of the new in-house brand cushion during the store tour, he managed to make the cushion become viral online. And this cushion generated unexpected exponential sales for which NFM wasn't ready. Once the cushion buzz and logistics and sales' success slowed down, the first question of the CEO was: "How can we do that again?". By forecasting social media trends (and millenials' behaviours) and getting ready in terms of supply chain, NFM can potentially manage to do that again. Thinking about the live stream huge sector in China, maybe NFM could look for 网红 celebrities to visit the store again?
• Focus, focus, focus. NFM is all about local domination. It is not trying to dominate everywhere like Google. It is geographically focused on Middle America and as the company knows more about the customers and their behaviour, it can replicate its model only when it is sure that the new geography would be similar. That explains the extension of NFM to Texas for instance. It is also focused on its different categories of products and won't extend a new sub-category unless it is highly correlated to the existing offering of products
• Digitize but keep things real for the customers (O2O). With a strong online competition, NFM has created a website which reproduces as much as possible the reality of the in-store offline experience with a guided tour interface, an ability to "feel" and "visualise" the products and talk to salesforce live with a (maybe artificial intelligence-type?) chat which enables customers to feel like they are in the store.
• Negotiate well but be fair with your suppliers. Think about loyal and long-term relations. When Mrs. Bee was running the sofa business a few decades ago, she used to negotiate prices aggressively with her suppliers and even undersold her suppliers to gain more market share in the area. Now that NFM is the leader in the sofa and flooring market in Middle America, the relationship with the suppliers has changed with a long-term approach. There is a constant feedback from the end-users to the suppliers, a sourcing system enabling NFM to find the best products for its customers, and a relative fairness in the display of branded and white label in-house products in the store. These elements which sustain high sales for NFM and its suppliers create trust and 'profit" for all the stakeholders.
• Take care of (and train) your employees. With a non-commission based system of salesforce but a real sourcing, training, scoring and ability to promote its salesforce, NFM has created an emulation and constructive corporate culture among its employees. It has indeed a very low employee churn. And its salesforce has at least a 60% sales conversion rate for the furniture business. (One of the marketing director told me indeed that clients buy furniture approximately every 7 to 8 years and are often ready to buy when they enter NFM store. With a strong training, this explains how the salesforce manages to convert visitors into customers so efficiently.)