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Geoff Gannon Investor Questions Podcast #2: What Do You Need to Know About Warren Buffett's Letter to Shareholders?

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Geoff Gannon
Feb 26, 2010
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Geoff Gannon Investor Questions Podcast #2: What Do You Need to Know About Warren Buffett's Letter to Shareholders?

Hey this is Geoff Gannon. And you’re listening to the Investor Questions Podcast. The show that answers questions from investors like you. If you have a question you’d like answered call 1-800-604-1929 and leave us a voicemail. That’s 1-800-604-1929.


Listen to Investor Questions Podcast #2: What Do You Need to Know About Warren Buffett's Letter to Shareholders?

On Saturday morning Warren Buffett will release his annual letter to Berkshire Hathaway shareholders. That’s tomorrow: Saturday February 27th at 8 a.m. eastern.

I get a lot of questions about Warren Buffett. He’s definitely the single most asked about topic. So I thought it would be a good idea to take some time before the letter comes out to talk about Buffett generally and the letter specifically.

Buffett was born in 1930. But his story really starts in 1914. That’s when a 20 year old kid named Ben Graham arrived on Wall Street. Graham was a prodigy. He worked his way up from errand boy to fund manager in just 12 years. From that point on - we’re talking 1926 to 1956 - Graham invested money his own way. He was basically the first hedge fund manager. Or at the very least one of the first hedge fund managers.

Wall Street was different back then. Brokers were focused on earning money off trades. Lending was loose. And clients could buy stocks with only 10% down. A lot of folks thought the market factored in all the news that was already out there. The only way the little guy could make money was by knowing stuff ahead of time. Either you knew something about the big traders and what they were planning to do. Or you knew something about speculative stocks. Maybe you knew a copper mine would be depleted faster than previously thought. Or you knew something about the business cycle or the price of some vital commodity.

That’s the sort of thing investors were looking for. An edge.

So Graham gets to Wall Street - sees all this - and basically decides everybody there’s an idiot. They weren’t born idiots. Some of these guys were really smart. But that didn’t stop them from saying really stupid things about stocks.

And what’s amazing about Ben Graham is that he saw this. He saw that people had been conditioned a certain way. That the environment on Wall Street had shaped the creatures that lived there and turned these otherwise intelligent men into idiots.

There’s a great passage in Graham’s autobiography explaining this. I’ll read it to you:

“As a newcomer - uninfluenced by the distorting traditions of the old regime - I could respond readily to the new forces that were beginning to enter the financial scene. I learned to distinguish between what was important and unimportant, dependable and undependable, even what was honest and dishonest, with a clearer eye and better judgment that many of my seniors, whose intelligence had been corrupted by their experience. To a large degree, therefore, I found Wall Street virgin territory for examination by a genuine, penetrating analysis of security values.”

That’s a terrific quote. It really is. Especially the part about “intelligence corrupted by experience”. I love that line. Because it’s so true. And it’s so Graham.

Anyway, that’s Ben Graham for you. Some people say he was shaped by the ’29 crash. Maybe. But I think that explanation is overused. If you read about the guy - and especially if you read his writings from before the crash - you realize Graham didn’t change much. I think some of the ways he presented his message changed. And the things he tried to teach the general public - yeah, I’d say those may have changed a bit - but the core of what Ben Graham was as an investor was there in 1926 when he started his investment fund. It was there in 1934 when he wrote his textbook for Wall Street analysts. And it was there in 1949 when he wrote his handbook for the average investor.

That’s where Warren Buffett comes into the story.

At some point between 1949 and 1951 Buffett picks up a book called The Intelligent Investor. That’s the one Graham wrote for average investors. And it gave Buffett his first glimpse of value investing.

Buffett later said that for him reading The Intelligent Investor for the first time was like being Paul on the road to Damascus. That sounds a bit like a joke. It isn’t. Buffett really meant it.

Paul had an experience that made sense of the world and gave him something to do for the rest of his life. Then Paul set out and did it. Same thing for Buffett. After reading The Intelligent Investor stocks made sense for Buffett. He never looked back. He was an investor. He was a value investor. And he was a disciple of Ben Graham from that moment on.

After college Buffett applied to Harvard Business School. They rejected him. He kept looking. One day he’s flipping through a course catalog. He sees Ben Graham’s name. And he decides to write a letter to Graham’s co-author and fellow Columbia professor - David Dodd.

Professor Dodd likes the letter. He accepts Buffett. Warren goes to Columbia. He becomes Graham’s star student. Gets an A+. And the rest is history.

Kind of. You may have heard all of this before but it’s worth telling it twice so everyone’s on the same page.

After Columbia Buffett goes back to Omaha for a bit but eventually ends up joining Ben Graham’s partnership. He works with his mentor as an analyst of sorts for a couple years. He learns Graham’s methods from the inside out. Gets schooled in arbitrage and things like that.

Then Graham retires and liquidates the partnership. This is 1955 and 1956.

So - around that time - Buffett goes back to Omaha and starts his own partnership with a hundred thousand dollars raised from some friends and family. He has tremendous success. Over the next 10 to 12 years Buffett’s fund gains 30% a year before fees. During the same time the Dow did 6% a year.

Buffett beat the Dow every year. And he never had a losing year.

It’s a remarkable record. Like a baseball player batting .400. Not for one season. But for a whole stretch of years.

That kind of performance should have put Buffett in the investment hall of fame. But here’s the thing: nobody knew the guy.

Yeah he made millionaires out of some doctors and lawyers in Omaha. So what? That kind of thing doesn’t draw any attention from New York.

Here’s how low key Buffett was. When he started his fund he was working out of his house. Buffett never had help from any employees. He did it all alone. Eventually he got people to help with paperwork and other clerical stuff. But he never hired anyone to assist him on the investment side of things. Ben Graham’s operation had always been tiny. But Buffett went even further than Graham in keeping things simple.

He was a one man show. And that word “show” is important. Because although Buffett was simple he wasn’t secretive. He wrote yearly letters to the investors in his fund explaining his approach to stocks. It was mostly Graham’s approach - at least at first - but the approach was laid out in Buffett’s own words.

And that’s where things get interesting for us. Why did Buffett write these letters?

A lot of investment managers - both then and now - don’t do a great job telling clients what the fund is up to. And they definitely don’t try to teach anybody anything. They draw a clear line between the professional and the amateur. And they make things sound complicate.

We all know doctors who have a good bedside manner and doctors who don’t. A lot of it comes down to looking at things from the other guy’s point of view. You tell him what matters to him in words he understands. You don’t try to impress him with jargon. And you don’t say things in the words you use day-to-day unless you’re sure he understands those words as well as you do.

What’s interesting about Buffett is that he worked on his bedside manner from very early on. He was born kind of shy. Kind of awkward. He took a public speaking class to get over that fear. And to learn a skill he thought he needed. He taught a local college course on investing. And he wrote these strange little letters to investors.

I say strange because they aren’t the kind of thing you’d expect a money manager to write his clients. In the 1959 letter he explains a typical situation in detail. He describes what he thought and when he thought it. He gives estimates of intrinsic value. And talks about how long it took to buy the shares he wanted at the price he wanted.

He never gave details about stocks the fund was currently buying. But he tried very hard to give his clients a clear picture of what they were investing in. Or who they were investing in. Because ultimately they were putting their trust in Buffett. They had to trust his skill. And they had to understand his approach.

Looking at it that way the partnership letters make sense. And they’re clearly a sign of what was yet to come: the annual letter to Berkshire Hathaway shareholders.

Buffett closed down his investment partnership in the second half of the 1960s. The stock market had gone kind of crazy. It doesn’t seem that way now because we all remember the Millennium Bubble. But at the time - in 1965 - stocks were more expensive than they’d ever been since 1929. At least by some measures. And they were almost exactly as expensive as stocks in 1929 if you look at the measurement I like best which is price divided by ten year average earnings. Whatever you and I think about how expensive stocks were in 1965 doesn’t matter. What matters is that Buffett thought stocks were pricey and he liquidated his partnership.

But he held on to one of the partnership’s investments. A New England textile maker called Berkshire Hathaway. He bought it cheap. Paying about 70% of net current assets. That means he paid 70 cents for each dollar of cash, receivables, and inventory after deducting all of the company’s liabilities.

It turned out to be a mistake. Buffett didn’t get out of the textile business for another 20 years. But he did take all the cash he could suck out of textiles and put it in other stuff. That’s how Berkshire Hathaway was reborn.

Buffett bought some insurance companies for their float. That’s the cash they control but expect to pay out in the future. If an insurance company keeps growing it always has more premiums than claims because it collects premiums first and pays claims later.

Some people have trouble with this idea. But it’s an important one. So I’ll use an analogy.

Think of some remote village of 100 people. If anthropologists go to that village in 1830 and again in 1890 they may find that in both cases the population is about 100. So the village has a stable population. But most of the actual villagers are different. In those 60 years some villagers were born. Others died. But if the birth rate and death rate are the same for those 60 years the population stays the same. It’s constant. And in that sense the village is immortal even though each and every villager is mortal. The village is permanent. Even though all of villagers are temporary.

Float works the same way. The premiums collected each month will all be paid out in claims eventually. In that sense each dollar in premiums an insurance company takes in gets paid out to policyholders eventually. But in another sense some of those dollars are always sitting around. So an insurance company’s float is a lot like a bank’s deposits.

Obviously I’m simplifying things. Some insurance companies pay out more in claims than they get in premiums while others do the opposite.

But here’s the point. You can think of an insurance company’s float as being like a bank’s deposits. Just having use of the money is valuable.

And Buffett’s been able to use this money - this float - to buy businesses and stocks.

One business Berkshire bought is See’s Candy. It’s a west coast candy company. A lot of people in the east have never heard of See’s. The company does almost no business out here. But it’s huge in California. The brand is worth a ton. Because of that Buffett raised prices at See’s Candy faster than inflation through the 1970s and 1980s. The company earned higher profits on each box of candy. And most of those profits went to Berkshire’s headquarters in Omaha for Buffett to invest. Very little cash had to be kept at See’s to grow the business.

Berkshire now owns lots of other companies. Some are names you know like: Fruit of the Loom, Dairy Queen, and Benjamin Moore. Others are names you don’t know. But they were all bought with cash Berkshire got either from businesses it already owned - like See’s - or from the float created by its insurance companies.

Berkshire is a cash sorting machine. It takes cash from one business and buys another business. Or it uses the cash that builds up in an insurance company. Most insurance companies buy bonds. Buffett prefers to buys stocks like Coca-Cola (KO) or Kraft (KFT) or Wells Fargo (WFC). Those stocks tend to do better than bonds.

And that’s how Berkshire makes its money. But that’s not why you should read Warren Buffett’s letter to shareholders.

Today Berkshire is a huge company. The stock’s best days are behind it. You should only buy stock in Berkshire Hathaway when it clearly looks cheap. In other words: you need to treat Berkshire like any other stock. You have to demand a margin of safety - a discount from its intrinsic value - before you buy it.

On Saturday morning Buffett will give you some idea of how cheap - or expensive - Berkshire’s stock is.

Near the start of the letter Buffett will talk about two yardsticks - or buckets of value - he uses to judge Berkshire. The two buckets are investments and earnings. He will give you the pre-tax earnings and total investments per share for the “A” shares. The “B” shares are 1,500 times smaller than the “A” shares. So you should divide the numbers he gives you by 1,500 to get the same data for the “B” shares.

I think the best way to value Berkshire is to look at those two yardsticks Buffett gives you. Then multiply the pre-tax earnings by 10. And finally add the investments per share. That will give you a rough estimate of what Berkshire is worth.

I’ll explain why you should value Berkshire this way in tomorrow’s episode.

For now I just want to get you to read Buffett’s letter on Saturday morning with an eye to how he thinks about investing. That’s the big takeaway for the average investor.

If you don’t own Berkshire Hathaway stock what matters to you is what you can learn from Buffett about investing.

You should try reading the letter 3 times. Read it once on Saturday morning. Then put it down and read it again that evening. Then sleep on it for a few days. Let all the noise die down. There will be news reports and blog posts - and yes - even podcasts about the letter. Listen to them if you want. Then come back to the letter next Saturday for one last read.

And see if your experience is the same each time. I’m not sure it will be. Sometimes knowing a piece of writing frees your mind to soak in some stuff you didn’t see the first time through.

Buffett’s letter is important because it’s an expression of what he believes. I told you Buffett once compared reading Ben Graham’s book to being on the road to Damascus. Well someone else once said value investors are like a religious group with their own books. Graham is the Old Testament. And Buffett is the New Testament.

Give Buffett’s letter the time it deserves. And you might just have the kind of epiphany Buffett had when he read Graham’s book.

I don’t know about that. But I do know that when you’re done reading Buffett’s letter on Saturday morning there will still be more than 30 years of past letters waiting for you at

Okay. That’s all for today. Remember this show depends on questions from investors like you. So if you have an investing question you want answered call 1-800-604-1929. That’s 1-800-604-1929.

Don’t forget to come back tomorrow for a new episode talking about Buffett’s latest letter to shareholders.

Thanks for listening.

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