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 with net-worth of $72 billion. Warren has created his wealth by making investments in various companies including stock markets. Warren 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. These letters have served as an avenue for Warren to communicate with the shareholders, explain his investment actions and their rationale.Warren’s letters 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.
In 1983, Warren wrote 13 business principles for shareholders of Berkshire Hathaway in which he added two more principles in 1996. Warren calls these principles “Owner’s Manual”, which lists out the expectations of Berkshire shareholder’s from Warren Buffett & Charlie Munger and vice versa. The manual communicates to the shareholders about objectives of Berkshire Hathaway, rationale of different decisions, information-reporting standards etc. Nevertheless, the manual contains many guidelines, which can be used by any stock market investor for selecting fundamentally sound companies.
In the current article, I have tried to present the key investment principles revealed by Warren in Berkshire Owner’s Manual.
Learning from Berkshire Hathaway’s Owner’s Manual
1) View Shares as Part-ownership in the Underlying Business
Warren advises stock market investors to see themselves as owners in the company’s business rather than holding a piece of paper in hand (or now in demat account), which can be sold whenever its price changes. This ownership attitude separates an investor from a speculator and forms the basis of fundamental stock investing.
“Charlie and I hope that you do not think of yourself as merely owning a piece of paper whose price wiggles around daily and that is a candidate for sale when some economic or political event makes you nervous. We hope you instead visualize yourself as a part owner of a business that you expect to stay with indefinitely, much as you might if you owned a farm or apartment house in partnership with members of your family”
2) Investors should Rejoice when Stock Markets Fall. It is Great News for them.
Warren advises that investors should be very happy to see a sinking stock market. There cannot be a better time to stock up their portfolio with excellent stocks at very cheap prices than the times when stock markets are sinking. Investors should buy as much as they can in falling markets.
“In this respect, a depressed stock market is likely to present us with significant advantages. For one thing, it tends to reduce the prices at which entire companies become available for purchase. Second, a depressed market makes it easier for our insurance companies to buy small pieces of wonderful businesses – including additional pieces of businesses we already own – at attractive prices. And third, some of those same wonderful businesses, such as Coca-Cola, are consistent buyers of their own shares, which means that they, and we, gain from the cheaper prices at which they can buy.
Overall, Berkshire and its long-term shareholders benefit from a sinking stock market much as a regular purchaser of food benefits from declining food prices. So when the market plummets – as it will from time to time – neither panic nor mourn. It’s good news for Berkshire.”
3) Invest in Companies with High Promoter’s Holding
Warren’s principles indicate that investors should focus on companies with high promoter’s stake. Warren says that it is beneficial for investors as the stakes of owners and investors remain aligned to each other.
“In line with Berkshire’s owner-orientation, most of our directors have a major portion of their net worth invested in the company. We eat our own cooking.
Charlie and I cannot promise you results. But we can guarantee that your financial fortunes will move in lockstep with ours for whatever period of time you elect to be our partner……… Moreover, when I do something dumb, I want you to be able to derive some solace from the fact that my financial suffering is proportional to yours.”
4) Investors should Analyse Companies by Per-share Parameters rather than Aggregate Size of the Companies, and
5) Avoid Companies which Frequently Resolve to Stock Issuance/Equity Dilution to Raise Funds citing that the Stock Issue is Undervalued
Warren believes in comparing companies’ performance on per-share basis rather than aggregate values. Warren’s principle cautions investor against companies that keep on issuing new stock/equity to raise funds to apply in operations. By such activities, companies are able to show larger asset base and higher sales but they hurt the interests of existing shareholders as their stake is diluted. Investors should always compare such companies’ performance based on per-share sales or assets to assess whether the company is creating or destroying value for shareholders.
“Our long-term economic goal (subject to some qualifications mentioned later) is to maximize Berkshire’s average annual rate of gain in intrinsic business value on a per-share basis. We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress.
We will issue common stock only when we receive as much in business value as we give. This rule applies to all forms of issuance – not only mergers or public stock offerings, but stock-for-debt swaps, stock options, and convertible securities as well. We will not sell small portions of your company – and that is what the issuance of shares amounts to – on a basis inconsistent with the value of the entire enterprise.”
Warren would be wary of the flurry of equity dilution, which is currently underway in many of the e-commerce companies in India. Every day, newspapers are filled with stories about the ‘n’th round of fund raising by such companies. The numbers being reported in the articles relate to total sales etc. Warren would advise the investor to see the promoter’s stake in the company before investing and understand whether they have created sufficient value for shareholders from the money raised.
Warren does not like companies where owners are more interested to gain by salaries from their companies rather than business profits.
“We have no interest in large salaries or options or other means of gaining an “edge” over you. We want to make money only when our partners do and in exactly the same proportion”
6) Investors should Invest in Debt-free or Low Debt Companies
Warren’s principles indicate that an investor should invest in companies, which are conservatively financed and do not carry large debts on their balance sheets. The investor should understand that debt-free companies never go bankrupt.
“We use debt sparingly and, when we do borrow, we attempt to structure our loans on a long-term fixed-rate basis. We will reject interesting opportunities rather than over-leverage our balance sheet. This conservatism has penalized our results but it is the only behavior that leaves us comfortable.……As one of the Indianapolis “500” winners said: “To finish first, you must first finish.”
7) Investors should Never Take Loans to Invest in Stock Markets
Warren believes that the risk of taking loans to make some extra money is not worth the effort & stress.
“The financial calculus that Charlie and I employ would never permit our trading a good night’s sleep for a shot at a few extra percentage points of return. I’ve never believed in risking what my family and friends have and need in order to pursue what they don’t have and don’t need.”
8) Investors should Avoid Companies which Frequently Acquire other Companies in the name of Diversification
Warren’s principles warn investors that such activities many times represent managerial hubris where companies’ management tries to achieve their self-aggrandizing motives at the cost of shareholders.
“A managerial “wish list” will not be filled at shareholder expense. We will not diversify by purchasing entire businesses at control prices that ignore long-term economic consequences to our shareholders. We will only do with your money what we would do with our own, weighing fully the values you can obtain by diversifying your own portfolios through direct purchases in the stock market.
Charlie and I are interested only in acquisitions that we believe will raise the per-share intrinsic value of Berkshire’s stock. The size of our paychecks or our offices will never be related to the size of Berkshire’s balance sheet.”
9) Investor should Monitor Business Progress of Companies and not their Stock Price Movements
Warren suggests that investors should focus on the business performance of companies in their portfolio and ignore their daily stock price movements. In fact, Warren believes that short-term price movements should be meaningless for investors. Investors should use such movements only to buy more shares if prices become attractive.
“….we think of Berkshire as being a non-managing partner in two extraordinary businesses, in which we measure our success by the long-term progress of the companies rather than by the month-to-month movements of their stocks. In fact, we would not care in the least if several years went by in which there was no trading, or quotation of prices, in the stocks of those companies. If we have good long-term expectations, short-term price changes are meaningless for us except to the extent they offer us an opportunity to increase our ownership at an attractive price.”
10) Investor should Check whether Management is Creating or Destroying Shareholder’s Value
“We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained.”
Warren believes that if a company is not able to generate wealth for its shareholders from the amount of profits it retains with itself, then it should release the money to shareholders (by way of dividends or share buybacks). It would allow shareholders to deploy their funds on their own.
11) When to Sell a Stock
Warren believes that if a company is doing well, then its stock should never be sold. Investors should stay invested in companies whose business is performing well, irrespective of their share price.
“Regardless of price, we have no interest at all in selling any good businesses that Berkshire owns.”
Therefore, we can see that Warren believes in fundamental stock investing. He prefers to invest in conservatively financed companies, which have good long-term prospects and run by honest & competent management. Whenever he finds such a company, he likes to hold it until its business prospects are maintained. If common investors like us repeat the same principles while selecting our stock investments, then we would also be able to select companies, which can generate good returns for our portfolios.
This concludes the current article in which I have summarized some of the key investing lessons from Berkshire Owner’s Manual written by Warren Buffett in 1983 and subsequently edited in 1996. 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.
If you have already read Warren’s letters, then it would be great if you could share your learning from it. I would be happy to get your feedback about the article and the website. You may write your inputs in the comments below or contact me here.