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Ong Kai Kiat
Ong Kai Kiat
Articles (10) 

Warren Buffett Explains Economic Gravity

Despite flawed accounting practices for book value, the market always finds a way to return a stock to its intrinsic value

Warren Buffett (Trades, Portfolio) is renowned as the value investor of our time with 52 years of investing experience. So it was with great pleasure that I read Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.Blatest newsletter to shareholders. Every year, Buffett presents new investment gems to readers.

Buffett recently described how he overcame his aversion and embraced technology companies such as Apple (NASDAQ:AAPL), IBM (NYSE:IBM) and Facebook (NASDAQ:FB) under the guidance of his younger managers. This year, the main highlight of his newsletter is the theme of economic gravity. Buffett wrote, “Over time, stock prices gravitate toward intrinsic value.” 

Asymmetrical accounting practices

According to Buffett, economic gravity comes about when there is a mismatch between a stock’s book value and intrinsic value due to asymmetrical accounting practices. Under the generally accepted accounting principles, the book values of his ownership of companies (holding majority shares) are written down when they underperform but are not written upward when they perform well.

While Buffett is a renowned investor, he has had his moments of misjudgment, but the right calls outnumber the wrong ones. For every flop like Dexter Shoes, he has megahits like GEICO and MidAmerican Energy.

Berkshire Return (1965 to 2016)

Source: Berkshire Hathaway

As seen in the consolidated performance table above, this means Berkshire's book value saw a compounded annual gain of 19% over 52 years, but its market value compounded by 20.8%. While the compounded annual gain of 1.8% might seem minor, it represents a difference of over 1.1 million percentage increases over the years.

Focus on normalized returns over actual returns

Businesses will always go through cycles. Even when your sector is doing well, there can be company-specific issues to work through. For instance, Berkshire recorded $1.1 billion of pretax losses due to Hurricane Sandy from various insurance businesses including GEICO in 2013.

Then there were times when Buffett did extremely well with his investments. For instance, he invested $5 billion in Goldman Sachs (NYSE:GS) in September 2008 after the collapse of Lehman Brothers. In 2013, Quartz calculated he earned $3.1 billion, a 62% gain.

Goldman Sachs

Source: Quartz

In the years immediately after the purchase, Goldman Sachs saw its share price fluctuate below his warrant price of $115. Today Goldman Sachs trades around $250 per share, which is way above Buffett's warrant price and is back to its pre-crisis levels. Berkshire continues to own 2.9% (or 11,390,582 shares) of Goldman Sachs, which effectively cost $654 million but is worth $2.86 billion today.

For Buffett, earnings and share prices may affect returns on a short-term basis, but investors should focus on the long term. In other words, investors should accept the bumpy ride for outstanding returns in the long run. This focus on the long-term results is a natural stress reliever for any investor.

Another important and often repeated lesson is that investors should stand ready to purchase significant shares of quality companies when irrational fear hits the market. This is where the big money is to be earned. The catch is to distinguish the strong from the weak and catch it at the right price.

When economic gravity fails

The market has its moments of inefficiency despite popular textbook theory. This is why hedge funds (e.g., Blackrock) and value investors (e.g., Berkshire Hathaway) can prosper year after year. Buffett stands ready to repurchase its shares when the price falls below 120% of its book value as it represents a significant discount to its intrinsic value. That is a value investor who is ready to act on his own advice.

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About the author:

Ong Kai Kiat
I am a freelance writer from Singapore who specialize in writing about finance and technology.

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