My Lesson from Warren Buffett on Known Knowns
Christopher Volk
A Background to My Story
In 2002, US Defense Secretary Donald Rumsfeld famously spoke of unknown unknowns. He didn’t invent the concept. More than 2000 years earlier, Greek philosopher Socrates created the Socratic Paradox centered on the acknowledgement of his own ignorance.
Three years before Secretary Rumsfeld’s introspective outburst, I was invited, along with a host of other public company leaders, to converge on the Omaha Country Club for the annual Omaha Golf Classic tournament organized by Warren Buffett. A major draw was that each of the foursomes would get to play a hole of golf with Warren and then later listen to him expound on the investing topic of his choice following the event dinner. I am an enthusiastic golfer, play generally badly and thoroughly enjoyed the experience. Warren cruised the golf club in his own cart, toting an oversized red and white Coca-Cola golf bag complete with seasoned clubs while meeting up with as many foursomes as he could.
After dinner, Warren spoke of the importance of understanding the companies in which you invest. He was not interested in unknown unknowns. He was drawn to known knowns. That’s what value investors do.
Planes, Trains and Automobiles
By the time I and other executives converged on the Omaha Country Club in the second week of September 1999, telecommunications and internet related shares were booming. The NASDAQ had climbed about 75% from 1581 at the beginning of 1998 to over 2800 and would nearly double again over the next six months. But Warren Buffett had missed out on the action. A giant wave of wealth had emerged out of thin air, but he wasn’t riding.
As dessert was being served and awards for tennis and golf excellence handed out, Warren stepped onto the small stage and launched into an allegory. He observed that two of the greatest inventions of the 20th century were the creation of automobiles and air travel and then proceeded to show what may have been his first two PowerPoint slides. On the first of these was a listing of every automobile manufacturer that had ever existed. And on the second was a comprehensive list of all the airlines that had ever flown. The lists took multiple columns, with the names of the industry players so small as to be barely legible.
While air and road travel were arguably the greatest two technological advances of the past century, Warren had one point to make. Had you invested in all of this, or gone long each industry, you’d have made no money. Most of the assorted companies failed or had low rates of return. And selecting ultimate winners would have had a high element of speculative luck involved.
Life altering technologies don’t come along that often. But, when they do, history is replete with stories of large-scale wealth creation and destruction.
Just thirty years prior to the incorporation of the Ford Motor Company in 1902, it was railroads that captured America’s imagination. Railroad development fever would soon lead to insolvencies that precipitated the panic of 1873. By 1874 about 120 railroads had become insolvent. Twenty years later, railroad speculation would again be center stage with the panic of 1893, which would see 150 railroad insolvencies. By1916, as Ford Motor Company was mass producing 500,000 cars annually, there were still over 1,500 railroads, of which hundreds had gone through bankruptcy, foreclosure or consolidation.
One of the many railroads to fail was the Detroit, Mackinac & Marquette Railroad (DM&M) which operated briefly in the upper peninsula of Michigan from 1881 to 1886. That small railroad was conceived and headed by James McMillan whose reputation would survive the failure. He went on to become a three-term US Senator. The adjacent photograph of a Gorham mixed metal silver punch bowl given Mr. McMillan by his former directors in January 1882 is a personal souvenir of this momentous period of irrational exuberance.
A History of Carnage
In discussing the speculative nature of chasing after automotive and airline stocks, Warren Buffett didn’t mention the internet boom or the dot-com stocks that grabbed headlines in 1999. He didn’t have to. The allegory he painted was clear and the business leaders in attendance received the message.
The resultant carnage from chasing companies tied to secular technology changes has a long tradition. The South Sea Bubble of 1720, ushering a new age of joint stock companies, counted such victims as Sir Isaac Newton. Eighty years earlier, it was the opportunity to invest in exotic Dutch Tulips. But in the US, the second industrial revolution headliner was railroads, which became the nation’s single largest most capital-intensive industrial sector, accounting for between 30% to 50% of capital formation. No other industry was close. It’s estimated that railroad investment losses between 1873 and 1893 amounted to over a $1 trillion in today’s dollars. But the actual economic impact was greater given the smaller size of the US economy at the time.
From its lofty perch six months after our Omaha Country Club dinner with Warren Buffett, the NASDAQ Composite Index would ultimately fall 75%, dragged down by the failures of internet related companies. Altogether, the number of internet and telecommunications company failures numbered in the thousands, with resultant wealth destruction estimated to be as high as $7 trillion. Like investments in trains, planes and automobiles, the internet would prove to be a life altering technology. And like its predecessors, early-stage investments in companies having undeveloped business models proved risky and speculative.
In his post dinner investment musings, Warren reiterated his often-expressed view of the importance of investing in businesses you fully understand. His clear inference was that it was important as an investor to adhere to known knowns. Technological advances alone did not deliver a ripe investing environment given a shortage of known knowns and an abundance of unknown unknowns.
On Business Models
In 2022, my book “The Value Equation: A Business Guide to Wealth Creation for Entrepreneurs, Leaders and Investors” was published. It’s among the few financially oriented books on business model fundamentals available. Business model financial fundamentals underpin long-term stock performance. So, when Warren Buffett speaks of the value of understanding what you invest in, this is the first thing I think about.
Transforming reported accounting results into informative business model frameworks takes some time but is worth the effort. Investment results are likely to be better and with less long-term risk. Understanding company business models does not make investing foolproof. The system elevates known knowns, but known unknowns and unknown unknowns can still pop up from time to time. They will simply be less frequent. For an illustration, look to my February Substack posting that examines Warren Buffett’s view of risk and his investment in STORE Capital, where I served as founding CEO.
This Time It’s Different
My recollection of a day and evening spent with Warren Buffett more than 25 years ago seems especially relevant today. Only this time, the life-altering technology is Artificial Intelligence, or AI. Here, as with the dot-com boom, business models have yet to be fleshed out. AI is not tech as we have ever known it. It’s asset-heavy tech, reliant on substantial investments in chips and data centers that have historically been avoided by otherwise asset-light companies. Such elevated business investment requirements, and revenue uncertainties present a foundation of unknown unknowns.
That AI is powerful is undeniable. How it will be monetized, what its return characteristics will be and who the winners will be remains speculative. As with airlines or automobile manufacturers in the 20th century, there will be winners. But the winners are not always headline participants. Beneficiaries of the success of planes and automobiles included oil companies, highway construction companies and the hospitality industry, just to name a few.
Investing without the safety net of proven business models is a dangerous high wire act. While many of the leading companies in the AI race have substantially greater financial wherewithal than their 1990’s dot-com participants, such offers modest respite from the elevated capital requirements and the many investment risks associated with unknown unknowns. And that’s what you have when you invest in a business having plenty of potential, but an undefined business model.
The refrain from investors in moments of euphoric anticipation is always that “it’s different this time.” But history suggests otherwise. Investors get the thesis right, but with prices that overshoot their marks.
10% is a Good Number
In 1999, at the time I attended Warren Buffett’s Omaha Golf Classic, I was President of a New York Stock Exchange-listed real estate investment trust. On a trip to meet prospective investors in New York City that year, I called on Tiger Management, a leading hedge fund started and led by iconic investor Julian Robertson. There, meeting with a portfolio manager, I was asked to predict the annual return I believed our company could deliver. I stated that we should be able to reliably deliver a return in the area of 12% annually. The portfolio manager dismissed the idea, noting he was looking to realize 12% each quarter. I departed with certain knowledge that Tiger Management would not be investing in our shares.
Where we stand today bears striking similarity. The S&P 500, the main broad measurement of stock performance, has historically delivered a long-term return not far from 10% annually. Only, over the past five years, the annual compound rate of return exceeds 14%. Meanwhile, the index has become far less diverse, with just ten companies commanding roughly 40% of the index value. That’s closing in on almost double the historic average. And the main driver of excess returns? The Magnificent Seven (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla) alone were responsible for about a third of S&P 500 performance. Then there was the contribution from other AI-related companies.
In such environments, realizing an annual 10% rate of return can seem quaint and uninteresting.
By the end of 1999, Nasdaq chalked up one of the finest performance years of any equity benchmark at better than 80%. And its five-year performance up until then was an equal outlier. Warren Buffett missed out on this epic run. But then he also missed out on the aftermath of the next five years. All the while, adhering to his investment approach, he had zero FOMO (fear of missing out).
My personal investing style is highly consistent with Warren Buffett’s approach, relying on my Value Equation framework. That said, I have not historically had the portfolio concentrations and comparatively large bets that have been hallmarks of Warren’s approach. And I have occasionally taken small momentum stock flyers, enjoying some rides, but cashing out on the way up and missing out on any number of high points. No matter. As a retiree dependent on portfolio performance and value, I embrace value investing fundamentals, the importance of known knowns and the knowledge that a 10% rate of return is more than satisfactory. Most of all, I know business model fundamentals underpin performance and adhering to this guidepost will both deliver returns and limit my risk.