Warren Buffett (Trades, Portfolio)’s annual Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) shareholder letters are filled with precious wisdom on investing, finance and business at large. His 1996 episode was no exception to being enlightening and insightful for alpha-seeking investors. Below, we highlight a couple of takeaways that we feel are significantly meaningful even after decades, but rather underleveraged among today’s investing community.
Low-frequency wins
“Inactivity strikes us as intelligent behavior. Neither we nor most business managers would dream of feverishly trading highly-profitable subsidiaries because a small move in the Federal Reserve's discount rate was predicted or because some Wall Street pundit had reversed his views on the market. Why, then, should we behave differently with our minority positions in wonderful businesses? The art of investing in public companies successfully is little different from the art of successfully acquiring subsidiaries. In each case you simply want to acquire, at a sensible price, a business with excellent economics and able, honest management. Thereafter, you need only monitor whether these qualities are being preserved.”
Investors are often their own worst enemy, thanks to multiple cognitive biases in today’s era of information explosion. They trade too often, resulting in not only a higher portfolio cost but also a tendency of committing more mistakes, including buying high and selling low, and overdiversifying with too many positions.
As Buffett implied, inactivity is the right approach for intelligent investors to follow. But it is more difficult to achieve than it looks. With the same investing strategy of buying wonderful businesses at reasonable prices at Urbem, we find it useful to completely disregard the stock market throughout our ongoing research, analysis and evaluation regarding a company. Nor do we listen to any serious degree to those mostly short-term forecasts from Wall Street prophets on the movement of the economy, interest rate and market – these belong to the category of known unknowns for us.
Look for things that seldom change
“In studying the investments we have made in both subsidiary companies and common stocks, you will see that we favor businesses and industries unlikely to experience major change. The reason for that is simple: Making either type of purchase, we are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek.
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Companies such as Coca-Cola and Gillette might well be labeled 'The Inevitables.' Forecasters may differ a bit in their predictions of exactly how much soft drink or shaving-equipment business these companies will be doing in ten or twenty years. Nor is our talk of inevitability meant to play down the vital work that these companies must continue to carry out, in such areas as manufacturing, distribution, packaging and product innovation. In the end, however, no sensible observer - not even these companies' most vigorous competitors, assuming they are assessing the matter honestly - questions that Coke and Gillette will dominate their fields worldwide for an investment lifetime. Indeed, their dominance will probably strengthen. Both companies have significantly expanded their already huge shares of market during the past ten years, and all signs point to their repeating that performance in the next decade.
Obviously many companies in high-tech businesses or embryonic industries will grow much faster in percentage terms than will The Inevitables. But I would rather be certain of a good result than hopeful of a great one.”
In our view, the primary goal of an equity investor is not to gain the most on the upside, but rather to protect the downside. To illustrate, a simple math equation shows how much percentage of return is needed to recover a certain percentage of loss (to break even). As Buffett indicated here, one way to reduce risk is to focus on stable businesses with a high certainty of a good return and stay away from disruptive ones that “might” end up spectacularly for investors.
Per our experiences at Urbem, we find it far tougher a job for winners to keep winning long term in an exciting, fast-moving industry. Failure to keep up with the new norm is one thing, while “crowded” capital and competition, both of which can be easily attracted to such an industry, also matter. This is why we get ourselves excited about many slower-growth areas full of boredom, such as pest control, hospice care and plumbing. Take a glance at the market leaders in those spaces - e.g., Rollins (ROL, Financial), Chemed (CHE, Financial) - and their consistently outperforming returns on capital.
Know your boundaries
“Should you choose, however, to construct your own portfolio, there are a few thoughts worth remembering. Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses.
Note that word 'selected': You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.
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Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards - so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value.”
Intelligent investing is simple but hard to do, as people have the psychological pulse to explore the unknown. Additionally, media continuously bring up new fancy concepts to attract eyeballs – e.g., autonomous driving, 5G, machine learning as of recent years. In our opinion, there are not just that many easily understandable (let alone predictable) businesses existing on this planet. But the good thing is that it does not necessarily take a lot of stocks for a portfolio to get “rich.”
At Urbem, we regard patience and objectivity as a valuable asset. Only with both of them can a high selectivity be accomplished. To us, investing is more about subtraction than addition. Starting from the total stock market down to our so-called “investable universe” consisting of less than 70 names as of now, we have to quickly pass the very majority of publicly traded companies around the world. From time to time, we have missed a few great businesses, which were firmly “agreed on” by our quantitative model but fell out of our knowledge boundaries. And we are totally fine with it.
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the financial market. We own shares of Berkshire Hathaway and Rollins.
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