In Search of Investment Wisdom—Reviewing Berkshire's Annual Shareholder Letters

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Feb 28, 2011
Long before his name was commonplace, a man from Omaha, NE, was quietly and rationally allocating capital, as only he can do, making lots of money for his shareholders in the process. We know him now as one of the world’s greatest investors — Warren Buffett. Although he hasn’t written a book on the subject, he pens an annual letter to Berkshire Hathaway shareholders. In those letters, you can find his investment nuggets of wisdom—some right out in the open, and some require a little thought. If you understand his approach holistically and apply it, you should do well for yourself. With the release of the 2010 letter this past weekend, there are exactly 34 letters in total, dating back to 1977. This will be the first article in a series which reviews each letter and extracts each nugget of investing wisdom for my commentary starting with the 1977 letter.

On Selecting Investments

“We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety.”

“We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people; and (4) available at a very attractive price.”

In the first quote, Mr Buffett is advising us of one very fundamental concept—you should approach a potential stock purchase with the same analysis and rigor that you would an outright acquisition. After all, stocks aren’t just pieces of paper, there’s a real business behind them.

In the second quote, he lays out his four filters for investment selection. Although not apparent up front, these items actually help protect the down-side. If you can understand how the business makes its money start-to-finish, and understand everything on the balance sheet, and its cash flows, then you’re in a better position to judge the condition of the business and establish a fair price it. If you don’t understand it, walk away. Secondly, a business with favorable long-term prospects will help you sleep at night by letting you peer into the future and make judgments about the viability of the company. Third, it’s imperative to pick trustworthy and competent management. Untrustworthy managers will lose you money (think Enron and Worldcom). Competent managers will make you money because excellent business acumen will eventually be reflected in business results, capital gains, and your pocketbook, over time. And of course, finally, there’s the issue of price. Pay attention to the price you pay relative to the fair value of the company. If you overpay, you’ll realize disappointing returns.

On Mr Market and Valuations

“Our experience has been that pro-rata portions of truly outstanding businesses sometimes sell in the securities markets at very large discounts from the prices they would command in negotiated transactions involving entire companies.”

“…bargains in business ownership, which simply are not available directly through corporate acquisition, can be obtained indirectly through stock ownership.”

“We ordinarily make no attempt to buy equities for anticipated favorable stock price behavior in the short-term. In fact, if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price.”

Ben Graham used an imaginary, manic-depressive investor named Mr Market to make his point that a wise investor chooses investments based on fundamental value rather than the opinions of others or the direction of the market. Here Buffett reminds us that the market gets very irrational at times slamming stock prices in the short-term. If the business fundamentals continue to be good, while the market price continues downward, then this is a good situation. If you’re in the market to buy, load up the truck!

On Judging Performance

Referring to capital gains of Berkshire, “While too much attention should not be paid to the figure for any single year, over the longer term the record regarding aggregate capital gains or losses obviously is of significance.”

“…we believe a more appropriate measure of managerial economic performance to be return on equity capital.”

“Most of our large stock positions are going to be held for many years and the scorecard on our investment decisions will be provided by business results over that period, and not by prices on any given day.”

“Just as it would be foolish to focus unduly on short-term prospects when acquiring an entire company, we think it equally unsound to become mesmerized by prospective near term earnings or recent trends in earnings when purchasing small pieces of a company; ie. marketable common stocks.”

Here Buffett reminds us not to fixate on short-term price squiggles in the market…focus on the business, and business performance over the long-term, not the short-term, just as you would if you bought the entire business. He then recommends a managerial metric for you to assess management against—return on equity capital. Good managers, regardless of whether the company is publicly-traded or privately-held, produce good return on equity (ROE) and return on capital (ROC). They know how to make money for their shareholders.

On Business Economics & Management

“A few shareholders have questioned the wisdom of remaining in the textile business which, over the longer term, is unlikely to produce returns on capital comparable to those available in many other businesses.”

“It’s comforting to be in a business where some mistakes can be made and yet a quite satisfactory overall performance can be achieved. In a sense, this is the opposite case from our textile business where even very good management probably can average only modest results. One of the lessons your management has learned – and, unfortunately, sometimes re-learned – is the importance of being in businesses where tailwinds prevail rather than headwinds.”

Referring to See’s Candies since purchase in 1972, “…pre-tax operating earnings have grown from $4.2 million to $12.6 million with little additional capital investment. See’s achieved this record while operating in an industry experiencing practically no unit growth.”

Here he instructs us to look for businesses with favorable economics and pricing power. If you focus on the business, you’ll come to realize some businesses just have better economics. Some require constant reinvest of large sums of capital just to maintain market share. The more money plowed back in just to maintain business operations, the less capital is then available to be deployed into growth opportunities or paid to shareholders, either as dividends or buybacks. As far as management ability—great managers can do little to truly affect the outcome of a business with terrible economics. However, if the business itself has great economics, you can be an average manager and still get great results. Good businesses also have pricing power, they don’t compete on price like commoditized businesses, ie. textiles, gasoline, etc. Look at his reference to See’s carefully…they tripled their operating earnings over a 5-year period with little additional capital expenditures and no unit growth for the industry…due to pricing power. See’s was able to continually raise the price for candy and people still bought it. Look for those kind of companies.

On Position Sizing

“When prices are appropriate, we are willing to take very large positions in selected companies, not with any intention of taking control and not foreseeing sell-out or merger, but with the expectation that excellent business results by corporations will translate over the long term into correspondingly excellent market value and dividend results for owners, minority as well as majority.”

Here, Buffett’s advice when you find a security to buy, and at the right price, is to make a sizeable and significant investment of it in your portfolio. If done right, these excellent business results will translate to corresponding capital gains over time inflating your portfolio in the process.

For a complete read, see the 1977 Berkshire Hathaway Shareholder Letter