Warren Buffett, CEO of Berkshire Hathaway, is one the most successful investors of all times. As per Forbes, he is currently the third richest person in the world with a net-worth of $72 billion. Warren has created this wealth by making investments in various companies including stock markets. No wonder that he is called the “Oracle of Omaha“. Warren is a living example of the success that a person can expect from stock market investing. He 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 he uses to select his investments. However, Warren has been writing letters to his investors and shareholders of Berkshire Hathaway for many decades. These letters serve as an avenue for Warren to communicate with the shareholders, explain his investment actions and their rationale.
Warren’s 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 Berkshire’s website. Each of the letters is a goldmine of knowledge for fundamental stock investors. In the current article, I have presented the eight key investment lessons revealed by Warren in his 1977 letter.
Learning from Warren Buffett’s Letter, 1977
1) Stocks Selection Criteria:
In this letter, Warren has listed out the key characteristics of the stocks that he considers investment-worthy.
“We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price.”
Warren indicates that an investor should look at stocks like part ownership in a company. The investor should always focus on buying companies in industries that she understands, are run by good management and available at attractive prices. The investor should never overpay for a stock.
However, whenever an investor comes across an opportunity in the industry that she does not understand then she should consider investing in it only after learning about the company & its business.
2) Always Hold Stocks for Long Term and Welcome Fall in Stock Prices:
Warren provides the reader a glimpse of his attitude towards stocks in his portfolio. He advises that investor should not buy equities in anticipation of increase in stock prices in near future.
“We ordinarily make no attempt to buy equities for anticipated favorable stock price behavior in the short term.”
Warren mentions in the letter that he bought insurance business of National Indemnity Company and National Fire and Marines in 1967. He has held them for 10 years by the time of writing of this letter in 1977.
A glance at the portfolio of investments of Berkshire Hathaway would indicate that Warren does not like to book profits in his stocks the moment they generate some capital gains.
Capital Cities Communications, Inc.
Government Employees Insurance (Company Convertible Preferred)
Government Employees Insurance (Company Common Stock)
The Interpublic Group of Companies, Inc.
Kaiser Aluminum& Chemical Corporation
Kaiser Industries, Inc.
Knight-Ridder Newspapers, Inc.
Ogilvy & Mather International, Inc.
The Washington Post Company Class B
All Other Holdings
The above table shows that Warren has been holding Kaiser Industries despite it having increased more than 6 times in value (a six-bagger!). Similarly, the portfolio has many companies, which has already doubled or tripled his investments like The Interpublic Group of Companies and The Washington Post, but he is still holding them.
An investor should stay invested in the companies until the business prospects are good. Share price of any given day should not be a reason to sell a stock. In fact, Warren advises that the investor should welcome the fall in stock prices of good companies with favorable business prospects as it provides an opportunity to buy more stocks at attractive prices.
“…if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price.”
3) Monitor Business Performance of Companies and not their Daily Stock Prices:
Warren states that:
“Most of our large stock positions are going to be held for many years and the scorecard on our investment decisions will be provided by business results over that period, and not by prices on any given day.”
Warren prefers to monitor stocks based on their business performance rather than the movement of their stock prices.
4) Do not Overemphasize Single Year’s Figures while Analyzing Investments:
Warren advises that investors not to rely upon single year’s performance figures while making investment decisions.
“Just as it would be foolish to focus unduly on short-term prospects when acquiring an entire company, we think it equally unsound to become mesmerized by prospective near term earnings or recent trends in earnings when purchasing small pieces of a company; i.e., marketable common stocks.”
The letter contains example of “Berkshire Hathaway” to illustrate this point.
In 1948, Berkshire Fine Spinning Associates and Hathaway Manufacturing (which merged in 1955) had combined earnings of about $18 million from 12 large mills. In comparison, the same year, Time Inc. and IBM had earnings of $9 million and $28 million respectively. Thus, the pro forma combined Berkshire Hathaway was an economic powerhouse in 1948. However, by 1964, Berkshire Hathaway had cost losses of $10 million over last decade and its net worth had eroded by almost 60%.
Therefore, an investor should never get influenced by recent increase in earnings of any company and always analyse average sales & earnings over long periods before making investment decisions. I believe that the investor should analyse the data of at least last 10 years for stocks analysis.
5) Do not Get Influenced by “Record Earnings” Reported by Companies Year on Year:
An investor should not be overly impressed by increasingly higher earnings reported by companies every year. She should compare it with the amount of additional funds employed by the company to achieve these earnings. The letter cites example of interest earnings in savings account to highlight it.
E.g. If a savings account has a deposit of INR 100,000 at start of year and the interest rate is 10% then at end of 1st year the interest earnings would be INR 10,000. If entire money were retained in the same savings account, then at start of 2nd year, the deposit would be INR 110,000. At same interest rate of 10%, in the 2nd year, the interest earnings would be INR 11,000, which is 10% higher than 1st year. The only reason for this higher earning is retention of earnings of 1st year.
By the same logic, if a business keeps on retaining its profits by denying shareholders any dividends, then it would keep on showing higher earnings each year. It might not necessarily due to managerial competence; instead, it might be only the result of higher capital at work in the business.
Therefore, we should analyze companies based on the returns generated on the incremental capital employed in the business and take “record earnings” with a pinch of salt.
6) Management is Very Important Criteria while Selecting a Company:
Warren mentions that he always tries to choose companies with honest and competent management. Warren clarifies that he prefers acquiring minority stake in good companies whenever such opportunities available in stock markets at attractive prices. He states that acquiring majority stake/complete buyout might provide them ability to manage operations and corporate resources, but they would not be able to provide management as good as already in place. Warren says that:
“In effect, we can obtain a better management result through non-control than control. This is an unorthodox view, but one we believe to be sound.”
Therefore, investors should buy stocks with proven good management. Whether it is buying out entire companies or investing in small stakes in stock markets.
Warren admits that his insurance operations are maintaining good profitability because its managers are willing to accept reduced business volumes in times of insufficient premium prices. It takes great managerial discipline to let competitors take away business, which is key to Berkshire’s insurance successes.
7) Avoid Companies Operating in Declining Industries:
Warren admits that the investments in its textile division were not producing desired results as the industry faced many challenges. On the contrary, insurance division was performing excellent because its business allowed it to generate satisfactory overall performance despite many mistakes.
“One of the lessons your management has learned – and, unfortunately, sometimes re-learned – is the importance of being in businesses where tailwinds prevail rather than headwinds.”
Therefore, an investor should choose companies which operate in industries facing favorable prospects.
Warren is not opposed to investing in good companies in no-growth industries. He appreciates his investments in See’s Candies, a confectionery store, which showed great business growth despite no growth in its industry.
8) Be Open to Admitting Mistakes:
The letter shows Warren admitting his mistakes of predicting optimistic business performance of textile division of Berkshire Hathaway, which could not be achieved during the year.
“We have mistakenly predicted better results in each of the last two years. This may say something about our forecasting abilities, the nature of the textile industry, or both.”
He also admits the mistakes done by the insurance division like unfruitful expansion of its insurance operations in Florida and start of some non-profitable operations over past years.
Being open to admit mistakes is a key quality of an investor. Some decisions of every investor are going to be proved wrong, either today or tomorrow. However, if an investor keeps an open mind and learns from her mistakes, then she can improve her investing skills and become a successful investor like Warren Buffett.
This concludes the current article in which I have summarized some of the investing lessons from Warren’s letter written in 1977. You may read the complete letter here.
In the future articles in this series, I would analyze 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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In case 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.