Warren Buffett, CEO of Berkshire Hathaway, is one the most successful investors of all times time. As per Forbes, he is currently the third richest person in the world. Warren Buffett is a living example of the success that a person can expect from stock market investing and is a role model for millions of investors around the world including me.
Warren has not authored any book that might contain his investment philosophy. Therefore, there is no detailed account of the stock analysis process that Warren uses to select his investment. However, Warren has been writing letters to his investors and shareholders of Berkshire Hathaway since long explaining his investment actions and their rationale.
These letters are one of the limited sources available, which provide an authentic view of his investment philosophy. His letters have helped all the readers, whether professional or amateur investors, to improve their investing skills.
Warren’s letters to shareholders of Berkshire Hathaway since 1977 are available at the company’s website. Each of the letters is a goldmine of knowledge for fundamental stock investors. In the current article, I have tried to present the key investment lessons revealed by Warren in his 1978 letter.
Learning from Warren Buffett’s Letter, 1978
1) Stock Markets are the Best Place to Buy Businesses at Discounted Prices. A ‘Flash Sale’ is Always on!
Warren Buffett prefers outright purchase of companies. However, such buyouts are usually at a premium to the share prices of similar businesses available in stock markets. Therefore, Buffett uses such opportunities to keep buying small stakes in such listed companies and benefit from “discount sales”.
“…we eventually are going to make considerable sums of money buying small portions of such businesses at the greatly discounted valuations prevailing in the stock market.”
“SAFECO (a company in Buffett’s equity portfolio) is a much better insurance operation than our own…..is better than one we could develop and, similarly, is far better than any in which we might negotiate purchase of a controlling interest. Yet our purchase of SAFECO was made at substantially under book value. We paid less than 100 cents on the dollar for the best company in the business, when far more than 100 cents on the dollar is being paid for mediocre companies in corporate transactions. And there is no way to start a new operation – with necessarily uncertain prospects – at less than 100 cents on the dollar.”
“Of course, with a minor interest we do not have the right to direct or even influence management policies of SAFECO. But why should we wish to do this? The record would indicate that they do a better job of managing their operations than we could do ourselves.”
I agree with Buffett that the stock market is a good place to buy an ownership interest in great businesses. In fact, I believe stock market investing is a form of entrepreneurship.
2) Stock Selection Criteria:
Similar to the letter of 1977, in the current letter as well, Buffett highlights the qualities of companies he prefers to purchase.
“We get excited enough to commit a big percentage of insurance company net worth to equities only when we find (1) businesses we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) priced very attractively.”
Many investors argue that good stocks should be bought at whatever price they are available in the markets. However, Buffett is against such logic. He believes in never overpaying for a stock, however good the opportunity may look like.
“We usually can identify a small number of potential investments meeting requirements (1), (2) and (3), but (4) often prevents action.”
(Read about my criteria of stock selection: Selecting Top Stocks to Buy: A Step-by-Step Process of Finding Multibagger Stocks)
3) No One can Predict Stock Market Movements.
Buffett believes that predictions of short-term market movements are impossible and investors should not fall prey to such behaviour. Buffett assures the investors that long-term outlook for stocks is always positive and an investor should always think stock investments with long term perspective.
“…we are optimistic about prospects for long term return from major equity investments held by our insurance companies. We make no attempt to predict how security markets will behave; successfully forecasting short term stock price movements is something we think neither we nor anyone else can do. In the longer run, however, we feel that many of our major equity holdings are going to be worth considerably more money than we paid, and that investment gains will add significantly to the operating returns of the insurance group.”
4) Avoid Short-term Trading in Stock Markets. Always Welcome the Fall in Stock Prices.
Buffett does not believe in selling out his stocks if their stock price rises shortly after his purchase. He clarifies that a long-term investor should avoid the temptation to book quick profits in stock markets and instead keep buying good companies at attractive prices.
“We are not concerned with whether the market quickly revalues upward securities that we believe are selling at bargain prices. In fact, we prefer just the opposite since, in most years, we expect to have funds available to be a net buyer of securities. And consistent attractive purchasing is likely to prove to be of more eventual benefit to us than any selling opportunities provided by a short-term run up in stock prices to levels at which we are unwilling to continue buying.”
Warren has always believed that for long-term investors in stock markets, lower stock prices are a boon. Such period provides opportunities to buy excellent companies at low prices, which helps create significant wealth for investors over the long-term. He has displayed this behaviour for his investments in Kaiser Aluminum & Chemical Corporation (KACC) during 1977-78.
Warren had 0.32 million shares of KACC in his portfolio, at an average price of $34.6 in 1977. Its share price fell more than 70% during 1978. However, Buffett, instead of panicking, utilized this opportunity to triple his investment in KACC. He bought 0.72 million additional shares at $9.25 and brought down his average cost of purchase from $34.6 to $17.0.
This investing behaviour of not panicking in face of market fall and buying heavily into stocks of good companies at lower attractive prices is the single most important quality expected from stock market investors. If an investor develops this quality as a habit, then she can create significant wealth from stock markets.
5) Institutional Investors are not Always Right.
Buffett advises investors against following institutional investors for their investment decisions. He establishes that institutional investors are also impacted by market trends and herd behaviour present in stock markets. A good investor should form her independent views about investing opportunities and keep buying stocks, if available at attractive prices.
“..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.”
“in 1978 pension managers, a group that logically should maintain the longest of investment perspectives, put only 9% of net available funds into equities – breaking the record low figure set in 1974 and tied in 1977. (during 1975-1978 Dow Jones Industrial Average declined from 852 to 805).
6) Investors should have Concentrated Portfolios.
Buffett advises investors to avoid having too many stocks in their portfolio and instead keep their investments in only a few very good stocks.
“Our policy is to concentrate holdings. We try to avoid buying a little of this or that when we are only lukewarm about the business or its price. When we are convinced as to attractiveness, we believe in buying worthwhile amounts.”
7) Avoid Companies Producing Commodity Products without any Sustained Business Advantage (Moat).
Buffett explains the problems which businesses producing commodity products without much differentiation from competitors. He uses the example of his textile business to help the investors understand that such business, due to oversupply & competition, have to price their products based on their operating costs and are not able to achieve a good return on capital. Investors should avoid investing in such businesses, as they may not prove to be good investments.
“The textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage. As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed. Such a supply-excess condition appears likely to prevail most of the time in the textile industry, and our expectations are for profits of relatively modest amounts in relation to capital.”
“Obvious approaches to improved profit margins involve differentiation of product, lowered manufacturing costs through more efficient equipment or better utilization of people, redirection toward fabrics enjoying stronger market trends, etc. Our management is diligent in pursuing such objectives. The problem, of course, is that our competitors are just as diligently doing the same thing.”
8) Return on Capital Employed (ROCE) is a Good Measure of the Strength of a Business.
Buffett uses the return on capital employed (ROCE) to assess the attractiveness of any business. He uses ROCE to communicate the weakening nature of textile business. He also explains a few of the common reasons leading to low ROCE in businesses.
“Textiles: Earnings of $1.3 million in 1978, while much improved from 1977, still represent a low return on the $17 million of capital employed in this business (7.6%).……capital turnover is relatively low reflecting required high investment levels in receivables and inventory compared to sales. Slow capital turnover, coupled with low profit margins on sales, inevitably produces inadequate returns on capital.”
Buffett uses the ROCE parameter again in the letter to explain the sustained attractiveness of one of his retail business “Associated Retail Stores, Inc.”
“Associated’s business has not grown, and it consistently has faced adverse demographic and retailing trends. But Ben’s combination of merchandising, real estate and cost-containment skills has produced an outstanding record of profitability, with returns on capital necessarily employed in the business often in the 20% after-tax area.”
9) Be conservative while Making Projections.
Buffett asks investors not to become over-optimistic with business prospects during good times. He advises them to keep their feet on the ground and take a holistic view of the business landscape including competitors, before assuming good business performance of their companies in future.
“…over the last three years…..Berkshire’s per share net worth virtually has doubled, thereby compounding at about 25% annually through a combination of good operating earnings and fairly substantial capital gains. Neither this 25% equity gain from all sources nor the 19.4% equity gain from operating earnings in 1978 is sustainable. The insurance cycle has turned downward in 1979, and it is almost certain that operating earnings measured by return on equity will fall this year.”
“Our present thinking is that our underwriting performance relative to the industry will improve somewhat in 1979, but every other insurance management probably views its relative prospects with similar optimism – someone is going to be disappointed. Even if we do improve relative to others, we may well have a higher combined ratio and lower underwriting profits in 1979 than we achieved last year.”
10) Reported Financial Numbers may be Misleading.
Warren Buffett explains to the investors that the financial numbers reported by companies in compliance with accounting rules may not always show the true business picture of a company. Buffett advises that accounting numbers should be taken with a pinch of salt. These numbers should at best be viewed as a close approximation of reality.
“In some of these your ownership is 100% but, in those businesses which are owned by Blue Chip but fully consolidated, your ownership as a Berkshire shareholder is only 58%. (Ownership by others of the balance of these businesses is accounted for by the large minority interest item on the liability side of the Balance Sheet.) Such a grouping of Balance Sheet and Earnings items – some wholly owned, some partly owned – tends to obscure economic reality more than illuminate it. In fact, it represents a form of presentation that we never prepare for internal use during the year and which is of no value to us in any management activities.”
“Because of various accounting and tax intricacies, the figures in the table should not be treated as holy writ, but rather viewed as close approximations of the 1977 and 1978 earnings contributions of our constituent businesses.”
11) Management Quality is the Most Essential Part of any Business.
Buffett, repeatedly, stresses on the quality of the management of his investee companies. He believes that an investor can provide only funds in a company; she may not be able to provide good management. Therefore, it is essential that she invest in companies, which are run by honest & competent managers.
“Our experience has been that the manager of an already high-cost operation frequently is uncommonly resourceful in finding new ways to add to overhead, while the manager of a tightly-run operation usually continues to find additional methods to curtail costs, even when his costs are already well below those of his competitors. No one has demonstrated this latter ability better than Gene Abegg.”
Buffett appreciates managers who do not go blindly after chasing higher sales numbers and are willing to lose business if the proposition is not profitable.
“If major factors in the market don’t know their true costs, the competitive “fall-out” hits all – even those with adequate cost knowledge. George is quite willing to reduce volume significantly, if needed, to achieve satisfactory underwriting, and we have a great deal of confidence in the long term soundness of this business under his direction.”
12) Accept Mistakes and Shortcomings.
Buffett owns up the responsibility for his erroneous decision. He also admits that some of the businesses of Berkshire did not perform well and that there is the scope of improvement. An investor should keep an open mind to changing facts and humbly accept if any of her decision goes wrong.
“We continue to look for ways to expand our insurance operation. But your reaction to this intent should not be unrestrained joy. Some of our expansion efforts – largely initiated by your Chairman have been lackluster, others have been expensive failures.”
“The homestate operation was disappointing in 1978. Our unsatisfactory underwriting, even though partially explained by an unusual incidence of Midwestern storms, is particularly worrisome against the backdrop of very favorable industry results in the conventional lines written by our homestate group.”
“George Young’s reinsurance department continues to produce very large sums for investment relative to premium volume, and thus gives us reasonably satisfactory overall results. However, underwriting results still are not what they should be and can be.”
This concludes the current article in which I have summarized some of the investing lessons from Warren’s letter written in 1978. You may read the complete letter here.
In the future articles in this series, I would analyse other letters written by Warren to shareholders of Berkshire Hathaway so that readers as well as the author can learn and benefit from Warren’s wisdom.
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