Learning from history is one of the best ways to become a better investor. This is especially true today given the wealth of easily accessible data available to the retail investor. In the words of Mark Twain, “history does not repeat, but it does rhyme.” In his 1978 letter to shareholders of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial), value investor Warren Buffett (Trades, Portfolio) discussed how the investment climate changed during the decade of the 1970s, and how he responded to those changes.
Buying bottoms
Berkshire Hathaway is an insurance company. One of the ways insurance companies make money is by investing in securities using the the premiums paid by customers. Buffett believes there are four main criteria that need to be satisfied for Berkshire to invest in an equity. First, they have to be businesses that he understands. Second, they have to have good long-term prospects. Third, they need to be run by well-intentioned and competent managers. Fourth, they need to be priced cheaply relative to their value. It was this final point that made it difficult for Buffett and company to invest in the early 1970s:
“In 1971 our total common stock position at Berkshire’s insurance subsidiaries amounted to only $10.7 million at cost, and $11.7 million at market. There were equities of identifiably excellent companies available - but very few at interesting prices. (An irresistible footnote: in 1971, pension fund managers invested a record 122% of net funds available in equities - at full prices they couldn’t buy enough of them. In 1974, after the bottom had fallen out, they committed a then record low of 21% to stocks).”
Buffett’s "irresistible footnote" is an excellent illustration of the tendency of investors to buy the top of the market and to sell its bottom. So what changed as the 1970s went on? The market entered a prolonged slump and Buffett capitalized:
“The past few years have been a different story for us. At the end of 1975 our insurance subsidiaries held common equities with a market value exactly equal to cost of $39.3 million. At the end of 1978 this position had been increased to equities (including a convertible preferred) with a cost of $129.1 million and a market value of $216.5 million. During the intervening three years we also had realized pre-tax gains from common equities of approximately $24.7 million. Therefore, our overall unrealized and realized pre-tax gains in equities for the three year period came to approximately $112 million. During this same interval the Dow-Jones Industrial Average declined from 852 to 805. It was a marvelous period for the value-oriented equity buyer.”
It should come as no surprise to anyone that the last decade has been a pretty poor time for value investors, with strategies like growth and momentum investing generally outperforming value. However, lessons from history can teach us that things tend to come around eventually.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Howard Marks: This Behavior Characterizes Almost Every Bubble
- What Is a Sustainable Growth Rate?
- Warren Buffett: Investing in Turnarounds Is Difficult
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