How Did an Eight-Year-Old Girl Stump Warren Buffett?

How did an eight-year-old girl stump Warren Buffett?... What was the secret meaning of her question?... Why Berkshire will be broken up...

Last week, something unusual happened at the Berkshire Hathaway (BRK-B) meeting...

Someone asked a tough question.

In front of 40,000 people, an eight-year-old girl asked investment legend Warren Buffett and his longtime business partner Charlie Munger why they had invested so much in low-return, capital-intensive businesses over the past 20 years, instead of buying great businesses like Buffett had for the first 40 years of his career.

Buffett and Munger were stunned...

They made jokes. They stalled. Then, they gave a series of excuses, some of which were simply nonsensical. Buffett said, "Wouldn't it be nice if we could run a railroad without investing in trains and tracks and bridges?" Other statements they made in reply were deeply misleading, as I (Porter) explain below.

Eventually, Buffett tried to explain that with their recent enormous investment in iPhone maker Apple (AAPL), they're back on track. But he never really answered the key question. Why did Berkshire move so far away from its core investment strategy when it bought BNSF Railway?

So how did an eight-year-old girl stump Buffett and Munger?

What was the real meaning of the question she asked?

I'll tell you the "rest of the story" after you watch the clip of the girl's question.

Be patient with the little girl. She's only eight. And she's really nervous, because she's reading a sophisticated question on the Jumbotron in front of 40,000 people... And she's addressing one of the world's richest men.

Notice the crowd's shocked response and the loud cheers at the end of her question. It was the best question of the day... And probably the best question ever asked at a Berkshire Hathaway annual meeting. (Click here to see the video.)

We've been told that the origin of the little girl's question was, in fact, our Digest from last March...

And, although I don't know for certain how many people in the crowd recognized the term "capital efficient" that the little girl used to describe the great investments that Berkshire made in the past. But I'm willing to bet that several thousand folks at the Berkshire Hathaway meeting are familiar with the term because of my work.

I've used those words for more than a decade to explain why some common stocks can produce much higher long-term results than others. Capital-efficient stocks have the unique ability to grow sales and earnings without requiring matching growth in capital investments. As a result, they can increase their dividends (or share buybacks) much faster than other companies.

One of the clearest examples of investing in capital-efficient businesses is homebuilder NVR (NVR)...

Unlike any other major U.S. homebuilder, NVR doesn't invest in land. Instead, it buys ready-to-build lots from developers, who must invest huge amounts of time and capital in buying raw land and then permitting it for housing. As a result, NVR is much more capital-efficient. It is a much better business.

Just compare the price of NVR with that of any other homebuilder in the U.S. over any period of time longer than 10 years. You'll be amazed at the difference.

Over the past 15 years, NVR's stock is up about 700%... despite the mortgage crisis. No other major homebuilder is up even half that much. Homebuilding is a commodity-like business. It's highly cyclical. Builders' fortunes are tied to the volume of homes for sale and resources available to buy those houses. Nobody is going to innovate a new, better house. How could one homebuilder be such a better investment than the others? Simple: NVR is capital-efficient. The others aren't.

So what kind of stocks should you buy?

If, like Berkshire Hathaway, you're interested in the highest possible long-term compounding results, then the answer isn't railroads and utilities. Those businesses require massive capital investments and have commodity-like or regulated pricing restrictions. Buffett admits that Berkshire should have invested in "capital light" businesses, but didn't because these kinds of investments weren't available at a reasonable price... so it "had to" buy BNSF and IBM instead.

Pure malarkey.

Berkshire purchased BNSF for around $50 billion in 2009. That was near the lows of the last big bear market, when great American businesses were selling for peanuts. Dozens – maybe hundreds – of great capital-efficient companies were trading at reasonable prices. In the fall of 2008, Buffett wrote an essay for the New York Times that urged Americans to buy stocks, saying it was one of the great opportunities of his lifetime.

Just look at where Berkshire's other top capital-efficient investments were trading back in 2009. Shares of both ratings agency Moody's (MCO) and credit-card titan American Express (AXP) traded for less than $30 per share. Moody's is now at $173 a share. AmEx, which has been slow to rebound from the crisis, is now at $101 a share.

What about consumer-electronics behemoth Apple (AAPL)? The quality of that business had been apparent to investors since the early 2000s, following late CEO Steve Jobs' return and its long string of hit new products. Berkshire obviously likes the business today (buying $40 billion of the stock). So why didn't it buy Apple back in 2009, when it was trading for less than $20 a share?

It's hardly fair to expect Berkshire to have bought every great stock at every low point in the market...

But the fact is, Berkshire didn't buy any of the dozens of great companies that were available. Not one.

Meanwhile, what Buffett and Munger said to this little girl was that they "had" to buy the railroad because there weren't any big enough capital-efficient companies to buy at the time.

That's just a lie.

They could have easily bought more shares of several choices from their own portfolio. Dozens of other great businesses – like fast-food chain McDonald's (MCD) and luxury jeweler Tiffany (TIF) – would have met all of their historic standards, and were trading at multidecade lows.

Again... it's unrealistic to expect Berkshire to always buy the best possible company. Nobody knows who that's going to be. But it's just as nonsensical to argue that they couldn't have bought any of them.

What bothers me even more about Buffett's and Munger's answer is that it's woefully misleading...

The truth is, Berkshire didn't merely buy BNSF because it couldn't find anything else to buy. How do I know? Because it borrowed half of the cash it used in the deal, and it funded 40% of the acquisition with stock, which was a terrible trade for Berkshire holders.

If Berkshire bought BNSF because Buffett had to put its capital to work, it wouldn't have borrowed any money. And it would have never used stock.

Buffett has explained again and again why using Berkshire stock to buy lower-quality businesses is a huge mistake. And it definitely was here, too. When we calculated the real cash return Berkshire has earned through last year on its purchase BNSF, we came up with a return on invested capital of 3.3% annually. Berkshire could have made more money buying a basket of corporate bonds. And it funded this terrible investment with stock.

In other words, this wasn't just a mistake. This wasn't just Buffett buying one bad stock. This was a huge investment that Berkshire didn't have enough cash to afford. It was an unforced error... one that he compounded by issuing shares.

The size of this transaction, the fact that stock was issued in this deal, and the fact that the railroad can only earn about 5% a year on its assets, mean that Berkshire's stock has become permanently impaired. That's a fact that neither Buffett nor Munger will address. But they should.

Berkshire's shareholders should realize that the company cannot perform anything like it has in the past. In the past, buying Berkshire was an almost foolproof way to beat the market. Going forward, it will no longer beat the market even half of the time.

That means, eventually, Berkshire will be split in two...

One half will own its slow-growing, capital-intensive, industrial businesses (like the railroad and the utilities). That company should employ a lot of debt financing and pay a safe dividend. The other half will be the "normal" Berkshire... the one that doesn't use much debt, doesn't pay a dividend, and is focused on high-quality investments and insurance companies.

This question of whether to split Berkshire up is only just beginning to heat up. That's the real meaning of the question the little girl asked. And while only a few people in the audience were smart enough to know what was really at stake at this year's meeting, I'm certain Buffett and Munger knew exactly what that question really meant. It won't be last time they face that question. Hopefully next time, they'll have a better answer.

I hope you'll remember two things about this smart little girl's question...

First, Berkshire simply isn't what it used to be. There has been a dramatic change in the balance of its assets. Far too many assets are locked up in low-return businesses. For decades, lots of good asset managers have used Berkshire stock as a kind of "ballast" in their portfolios – a place to put a big chunk of their portfolios that they knew would be safe and likely to generate excess returns.

If you're invested in funds that hold Berkshire, ask your money manager if he's aware of this fundamental change in the stock. If he gives you answer like Buffett and Munger's, close your account.

Second, I hope you'll learn more about the profound difference investing in capital-efficient companies will make in your portfolio over time.

Soon, we'll offer our subscribers access to the Stansberry Terminal. (We start beta testing this month.) This software will show you the capital efficiency of more than 4,000 separate companies at the click of a button, allowing you to quickly figure out the most capital-efficient businesses in any industry.

Whatever you want to invest in, you can usually find a capital-efficient way to do it. In the meantime, look for companies that are able to routinely return more capital to shareholders (via dividends and buybacks) than they spent on making acquisitions or capital investments in their own company.

One last note...

Last night, Steve Sjuggerud, Dr. Richard Smith, and I hosted a live event discussing his TradeStops service, how to know exactly when this bull market will end, and how to protect your portfolio from disaster.

If you missed it, don't worry... We've put together a replay for you. It's completely free of charge. And even if you aren't interested in signing up for Richard's excellent TradeStops service, I think you'll find it to be well worth your time. You can watch the replay right here.

New 52-week highs (as of 5/10/18): Apple (AAPL), Automatic Data Processing (ADP), Amazon (AMZN), First Trust Nasdaq Cybersecurity Fund (CIBR), Cisco (CSCO), Eaton Vance Enhanced Equity Income Fund (EOI), Intel (INTC), Midas Gold (MAX.TO), Microsoft (MSFT), Okta (OKTA), Pioneer Natural Resources (PXD), and United States Commodity Index Fund (USCI).

A busy day in the mailbag: Feedback on yesterday's response to paid-up subscriber Scott G., and several notes on last night's TradeStops event. What did you think? Let us know at feedback@stansberryresearch.com.

"Porter, thanks for being such a great role model in your response to the provocation attempted by Scott G in his hostile letter to you. Accusing you of being able to be bought was the kind of low blow that only a recent subscriber would stoop to; all of your long term subscribers would know you too well. Maybe you should not accept comments (or at least publish them) until a reader has been subscribing for a certain number of years... Most folks would respond harshly to such an assault as Scott's. You demonstrate who you are by being above that. Thanks." – Paid-up subscriber Timothy S.

"Just wanted to commend Porter on his response to Scott G. It was comprehensive without being verbose, and it was incisive without being condescending. He took the high ground with his usual thoughtful and classy reply. Porter is a first-class equity analyst but maybe even a better writer. Paying for an Alliance membership was truly one of my best decisions. I always have been made to feel like I got the better end of the deal – a concept which Porter alluded to and certainly embodies in both his personal and business relationships." – Paid-up subscriber Joe V.

"Porter, you are to be commended, again, for your forthright, transparent, explanation of your business relationships. After many, many years of reading financial and other newsletters, I have never read anyone fully explain their business relationships and strategies as you just did. Thank you." – Paid-up subscriber Howard S.

"I had to write in because I've been a Stansberry member for 8 years, and I TRUST Porter and know his connections are genuine. Disagree on his stock picks or his outlook on the market, but you can't deny the rock star team he has assembled over the years. Doc Eifrig, Steve Sjuggerud and Tradestops founder Richard Smith, all have outstanding backgrounds, so when I watched the Crypto Capital video with Tama Churchouse with Porter's name attached to it, I knew what Tama had to say about Blockchain was gold. I had been searching for a respectable, non-biased voice out in the crypto space, but it's nearly impossible to tell the experts from the frauds. Almost everyone has an agenda, and I couldn't bring myself to trust anyone's advice, let alone pay for a subscription. All I can say is Thank You! Also, I'll wager any winner from Scott G's portfolio against my winners, and I'll guarantee it'll trounce his. One particular in my blockfolio is over 3,000% as of right now." – Paid-up subscriber Dan C.

"Thanks for putting all the talent on the webinar tonight. I'm already a very satisfied lifetime subscriber. But, I have found every time I listen in I pick up a new idea to use with TradeStops." – Paid-up subscriber Don B.

"Just finished the webinar with Porter, Steve, and Richard. You just hit another home run. The amount of time and valuable information that you share with us is simply incredible. Thank you. I am also an Alliance Member, a Lifetime Member of TradeStops as well as a member of TradeSmith Ideas.

"My wife and I have a 'two comma' portfolio and before I became an Alliance Member last year, we were paying a financial planner between $12,000 to $18,000 per year to manage our portfolio. Porter, you and your team and the learning that you provided in this most recent webinar, and on an ongoing basis is more than we received from the nearly five years we were associated with the financial planner combined. We have more than paid for all of our subscriptions to Stansberry Research, TradeStops, and TradeSmith Ideas from you and Dr. Smith's recommendations plus we have eliminated the financial planners bill. Thank you again.

"I do have a question that relates to TradeStops and to the Income Portfolio that we have placed a portion of our investments in. Currently there are six recommendations in the Income Portfolio that are in the 'Red Zone.' Those six that are in the 'Red Zone' vary from 1+ week to three that have been in the Red for 3+ weeks, with one in the Red for 7+ months. Why haven't you given the recommendation to 'Stop' out of them when everything TradeStops instructs us to do is just that... Stop out of the Red? Should I stop out of these six recommendation that are in the 'Red Zone' now and go to cash? Keep up the great work." – Paid-up Stansberry Alliance member Harry D.

Porter comment: Harry, it's a great question. This question, about how to use TradeStops versus how to use our research, is one that we get often. Other similar questions focus on the difference between TradeStops trailing-stop loss levels (including TradeStops volatility-based stops) and the ones we commonly recommend in our newsletters.

So... should readers use the allocations and the trailing-stop levels that we recommend? Or should they use the allocations, trailing stops, and even the timing models (including the green, yellow, and red zone indicators) that TradeStops recommends?

My answer: It depends.

At Stansberry Research, we're focused on doing in-depth fundamental research. We're trying to find great investment ideas based on any number of fundamental factors – that is, we're researching events, trends, and new technologies that we believe will influence stock prices. We study factors "outside" the stock market to gain insight into where stock prices will move next.

For example, we believe that Chinese "A share" stocks are going to do well over the next several months because of a major fundamental change in the way global stock indexes are being constructed. We believe hundreds of billions will flow into major Chinese stocks over the next 12 to 18 months.

We don't believe that technical models like Richard's could predict or indicate this opportunity. We make our investment decisions based on these fundamental factors – things beyond merely looking "inside" the market... things like stock price, volatility, and volume trends.

We only have relatively basic advice to give about risk management (trailing stops) and position sizes because fundamental investment research really doesn't offer much of a guide about these factors. So where we believe the fundamentals are particularly compelling, we might recommend taking a larger-than-normal position size. Or we might caution that a stock is likely to be volatile, so we recommend using a larger-than-normal trailing stop. We're not focused on analyzing what's happening with the stock's internal dynamics, because we believe that fundamental factors will prove to be more important.

Richard's approach to investing is very different. Thus, the tools he has built at TradeStops are very different.

Richard essentially ignores fundamentals. Instead, he relies on researchers like us (and a handful of other highly qualified newsletter writers, plus about a dozen different billionaires' portfolios) to come up with several hundred qualified investment ideas. From there, he relies on technical factors "inside the market" – like a stock's price action, its relative level of volatility, and other proprietary measures to determine which of the qualified stocks to buy, how much of each stock to buy, and when to sell.

Many subscribers admire Richard's approach. They believe there's much to be gained by combining both a fundamental approach (like our research) and Richard's technical approach.

Of course, I can't give you any personal advice. We provide the tools. You must decide how to use them.

But I have no doubt that Richard's allocation tools (deciding how much to invest in each stock) and his volatility-based trailing stops have significantly improved our recommended portfolio's results in the past.

As always in finance, past results don't guarantee future returns. We can't know for certain that his tools will continue to perform so well, but I think it's virtually certain that they will. These tools optimize the kind of "gut" feelings we have as fundamental investors with a mathematical precision that we simply can't match.

On the other hand, I am much less convinced that Richard's stock "state indicator" is a valid method of improving results. I do believe that only owning "green state" stocks can greatly lower the volatility of your portfolio. Doing so could allow you to invest more capital without taking on additional risk. In that way, it could also improve your total returns.

But I don't believe it would increase your return on invested capital. Thus, I don't currently recommend following his green, yellow, or red indicators. That's purely my own opinion, however, and I'm sure Richard would have a well-proven rebuttal. I just don't think there's any reliable way to judge short- to medium-term price action in thousands of individual stocks.

I hope that helps you decide how to best put these tools to good use.

Regards,

Porter Stansberry
Baltimore, Maryland
May 11, 2018

P.S. I've just finished my first real advertisement for my razor company, OneBlade. I'd love your feedback on it. And if you've never seen what I built, I hope you'll at least take a look. Click here to watch it.