Warren Buffett’s latest letter to Berkshire’s shareholders (2014) was released last week. It is a landmark letter as it marks the 50 years of Berkshire Hathaway under Warren Buffett & Charles Munger. Buffett & Munger have made the current letter special by explaining reasons of Berkshire’s success over last 50 years.
The current letter is a treat for investors, as it contains insights into Warren Buffett’s philosophy covering all aspects of stock investing. It has Buffett’s ideas on investing & its best avenues, desirable traits of investors and avoidable behaviors of investors. This letter contains Buffett’s advice about the kind of stocks investors should buy, how many stocks to buy, how much to pay for and when to sell.
This current letter is as informative as a complete book on stock investing. It is one of the best reads for investors and is very helpful for both professional and amateurs.
Warren’s Message to Investors
In the current article, I have presented Warren’s messages, which are important for an individual investor. Warren’s messages in the letter cover all aspects of stock investing:
- What is the best & the safest investing option
- Desirable Habits for a Stock Investor
- Avoidable Habits for a Stock Investor
- How to Select Good Stocks to Buy
- How Many Stocks to Buy
- When to Sell a Stock
- Two Final Mantras
(A) What is the Best & the Safest Investment Option
1) Stocks are the Best & the Safest Investment Option:
Warren Buffett tells the investors that stock investing is the best investment option available to anyone. Contrary to popular belief, stocks are the safest investment available. Stocks have proved this in last 100 years and will prove this again over next 100 years. Investors should prefer stocks to other fixed income securities like bonds, fixed deposits etc. Stocks have proved to be the best investment despite great debacles like world wars and recessions. Such big troubles would come in future as well and still stocks would reward their investors.
“The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities – Treasuries, for example – whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.”
“Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.”
2) Small Percentage Points can make Huge Difference in Overall Returns:
The moment a reader opens Buffett’s letter, she is presented with the table containing amazing figures of returns of Berkshire Hathaway over past 50 years (1964-2014). This table displays one of the key features of compounding returns: even small percentage points can make big differences over long periods.
In Per-Share Book Value of Berkshire (A)
In Per-Share Market Value of Berkshire (B)
Compounded Annual Gain 1965-2014
Overall Gain 1965-2014
The above table shows that in 50 years (1965-2014), Berkshire’s book value grew at an annual growth rate of 19.4% and therefore, $1 in book value in 1965 became $751,113 in 2014. Similarly, in 50 years, Berkshire’s market value (share price) grew at an annual growth rate of 21.6% and therefore, $1 in share price in 1965 became $1,826,163 in 2014.
We can see that the huge difference between the overall gain of book value and market value (1,075,050%) is made by a tiny difference in annual growth rate (2.2%). This calculation is a lesson for each investor that she should never underestimate the importance of small percentage gains over long term. This small difference in returns can be due to extra return earned or a small expense saved.
Investors should always choose investments, which have provided higher returns over long periods. Stocks are the best in this aspect. If an investor decides not to invest directly in stocks, she should use mutual funds to invest in stocks.
Therefore, in Indian markets, investors should always invest in direct plans instead of regular plans of mutual funds. Direct plans have lower expenses and provide higher returns of about 0.5% to 1.5% over regular plans of same mutual fund scheme. This incremental return is without any additional risk because investor’s money is invested in same stocks in both direct plan and regular plan. The difference in returns is because of the fact that for direct plans, mutual funds do not need to pay commission to distributors.
(B) Desirable Habits for a Stock Investor
1) Read Voraciously:
Both Warren Buffett and Charles Munger have stressed a lot on continuous reading for becoming good investors. Charles tells about responsibilities of Berkshire Chairman:
“His first priority would be reservation of much time for quiet reading and thinking, particularly that which might advance his determined learning, no matter how old he became.“
Warren Buffett has even recommended two books to investors in the current letter.
“If you haven’t read Schwed’s book (Where Are the Customers’ Yachts?), buy a copy at our annual meeting. Its wisdom and humor are truly priceless”
“Rather than listen to their siren songs, investors – large and small – should instead read Jack Bogle’s The Little Book of Common Sense Investing.”
Also Read: Getting the Right Perspective towards Investing.
2) Do not fear Short-term Fluctuations in Share Prices and always invest for the Long-term.
Warren advises investors that they should ignore short-term fluctuations in the market prices and focus on the long-term investment horizon. Reacting in panic to short-term price declines can be very detrimental to stock investors. Warren says that investors should not invest in stocks for less than 5 years and should ideally look for multi-decades investment horizon.
“If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things. Recall, if you will, the pundits who six years ago bemoaned falling stock prices and advised investing in “safe” Treasury bills or bank certificates of deposit. People who heeded this sermon are now earning a pittance on sums they had previously expected would finance a pleasant retirement. (The S&P 500 was then below 700; now it is about 2,100.) If not for their fear of meaningless price volatility, these investors could have assured themselves of a good income for life by simply buying a very low-cost index fund whose dividends would trend upward over the years and whose principal would grow as well (with many ups and downs, to be sure).”
“For those investors who plan to sell within a year or two after their purchase, I can offer no assurances, whatever the entry price. Movements of the general stock market during such abbreviated periods will likely be far more important in determining your results than the concomitant change in the intrinsic value of your Berkshire shares. As Ben Graham said many decades ago: “In the short-term the market is a voting machine; in the long-run it acts as a weighing machine.” Occasionally, the voting decisions of investors – amateurs and professionals alike – border on lunacy”
“Since I know of no way to reliably predict market movements, I recommend that you purchase Berkshire shares only if you expect to hold them for at least five years. Those who seek short-term profits should look elsewhere.”
“For the great majority of investors, however, who can – and should – invest with a multi-decade horizon, quotational declines are unimportant.”
3) Never borrow to invest in Stocks. It can be Disastrous.
Warren Buffett warns investors against borrowing money to purchase stocks.
“Another warning: Berkshire shares should not be purchased with borrowed money. There have been three times since 1965 when our stock has fallen about 50% from its high point. Someday, something close to this kind of drop will happen again, and no one knows when. Berkshire will almost certainly be a satisfactory holding for investors. But it could well be a disastrous choice for speculators employing leverage.”
“Indeed, borrowed money has no place in the investor’s tool kit”
4) Never take your Broker’s Advice on Face Value. Always do your Own Analysis.
Warren Buffett cites examples of mergers & acquisition of companies to advise investors that they should never buy or sell stocks based on their brokers. They should do their own analysis before buying or selling. Most of the times buying right and sitting tight is the best investment strategy. But the broker might advise trading for generating her trading commissions.
“..But sitting tight is seldom recommended by Wall Street. (Don’t ask the barber whether you need a haircut.)”
“And no advisor, economist, or TV commentator – and definitely not Charlie nor I – can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.”
“Investment bankers, being paid as they are for action, constantly urge acquirers to pay 20% to 50% premiums over market price for publicly-held businesses. The bankers tell the buyer that the premium is justified for “control value” and for the wonderful things that are going to happen once the acquirer’s CEO takes charge. (What acquisition-hungry manager will challenge that assertion?)”
“A few years later, bankers – bearing straight faces – again appear and just as earnestly urge spinning off the earlier acquisition in order to “unlock shareholder value.” Spin-offs, of course, strip the owning company of its purported “control value” without any compensating payment. The bankers explain that the spun-off company will flourish because its management will be more entrepreneurial, having been freed from the smothering bureaucracy of the parent company. (So much for that talented CEO we met earlier.)”
5) Never Overpay for a Stock; However good the Opportunity may seem, have Patience.
Buffett advises investors to buy stocks only when they are at attractive valuations. Buffett is not supporter of the philosophy of keep on buying good quality stocks regardless of price. Buying stocks without regard to its current valuation is speculation where the investor expects to gain from finding another investor willing to purchase that share at even higher price, irrespective of business growth of the company.
“Of course, a business with terrific economics can be a bad investment if it is bought for too high a price.”
“This cheery prediction comes, however, with an important caution: If an investor’s entry point into Berkshire stock is unusually high – at a price, say, approaching double book value, which Berkshire shares have occasionally reached – it may well be many years before the investor can realize a profit. In other words, a sound investment can morph into a rash speculation if it is bought at an elevated price. Berkshire is not exempt from this truth.”
Charles Munger highlights the habit of Buffett about never overpaying for a stock and keep waiting for good opportunities, in his section of the letter.
“Buffett often displayed almost inhuman patience and seldom bought. For instance, during his first ten years in control of Berkshire, Buffett saw one business (textiles) move close to death and two new businesses come in, for a net gain of one.”
Also Read: How to do Valuation Analysis of a Company?
6) Always be ready for the worst in Stock Markets.
Warren Buffett advises investors to always expected to unimaginable in the stock markets. You never know what awaits you tomorrow.
“The reason for our conservatism, which may impress some people as extreme, is that it is entirely predictable that people will occasionally panic, but not at all predictable when this will happen. Though practically all days are relatively uneventful, tomorrow is always uncertain. (I felt no special apprehension on December 6, 1941 or September 10, 2001.) And if you can’t predict what tomorrow will bring, you must be prepared for whatever it does.”
(C) Avoidable Habits for a Stock Investor
Warren Buffett has clearly highlighted the habits, which make an investor miss the gains that she could have made in stock investing. He advises investors against:
- Active trading,
- Attempt to time the market movements,
- Inadequate diversification,
- Paying high fee to advisors and
- Borrowing money to invest in stock markets.
“Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to “time” market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy. Indeed, borrowed money has no place in the investor’s tool kit: Anything can happen anytime in markets. And no advisor, economist, or TV commentator – and definitely not Charlie nor I – can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.
(D) How to Select Good Stocks to Buy
1) Invest in Companies, which would be in Business even after Hundred Years from now.
Buffett advises investors to invest in companies whom investors can imagine being in business for centuries. Such companies can generate huge wealth for their shareholders over long time horizon.
“A century hence, BNSF and Berkshire Hathaway Energy will still be playing vital roles in our economy. Homes and autos will remain central to the lives of most families. Insurance will continue to be essential for both businesses and individuals. Looking ahead, Charlie and I see a world made to order for Berkshire”
“Our confidence is justified both by our past experience and by the knowledge that society will forever need massive investments in both transportation and energy.”
Warren Buffett tells the investors qualities of companies, which would have the financial power to stay in business for 100 years:
“Financial staying power requires a company to maintain three strengths under all circumstances: (1) a large and reliable stream of earnings; (2) massive liquid assets and (3) no significant near-term cash requirements. Ignoring that last necessity is what usually leads companies to experience unexpected problems: Too often, CEOs of profitable companies feel they will always be able to refund maturing obligations, however large these are. In 2008-2009, many managements learned how perilous that mindset can be.”
2) Always buy Good Businesses. Never get lured into Buying Average or Bad Businesses, However low the Stock Price may be.
Warren advises investors to focus on buying good businesses only. He would have detested the idea of investing in any company only for the reason that its share price is in pennies.
“From my perspective, though, Charlie’s most important architectural feat was the design of today’s Berkshire. The blueprint he gave me was simple: Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices.”
Also Read: How to do Business Analysis of a Company?
3) First, look for the Opportunities in your Existing Portfolio.
Warren believes in making incremental investments in the existing stocks in the portfolio. He has been doing it in the past and has done it in 2014 as well.
“Berkshire increased its ownership interest last year in each of its “Big Four” investments – American Express, Coca-Cola, IBM and Wells Fargo. We purchased additional shares of IBM.”
4) Past Performance may not be repeated in Future, but it is a good measure for a Stock’s Quality.
Warren Buffett has highlighted the key qualities of the companies that he prefers to buy. One of these qualities is demonstrated consistent earnings power. He believes that past performance rather than future projections are much reliable criteria for judging stocks.
“We are eager to hear from principals or their representatives about businesses that meet all of the following criteria:
(1) Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units),
(2) Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations),
(3) Businesses earning good returns on equity while employing little or no debt,
(4) Management in place (we can’t supply it),
(5) Simple businesses (if there’s lots of technology, we won’t understand it),
(6) An offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).”
Also Read: How to do Financial Analysis of a Company?
5) Accounting Rules do not always reflect the Real Business Picture.
Buffett advises investors not to rely completely on accounting numbers, as they may not reflect the true business situation of a company. Buffett highlights many shortcomings of accounting standards in the letter.
“If our revolving float is both costless and long-enduring, which I believe it will be, the true value of this liability is dramatically less than the accounting liability. Owing $1 that in effect will never leave the premises – because new business is almost certain to deliver a substitute – is worlds different from owing $1 that will go out the door tomorrow and not be replaced. The two types of liabilities are treated as equals, however, under GAAP.”
“Fortunately, that does not describe Berkshire. Charlie and I believe the true economic value of our insurance goodwill – what we would happily pay for float of similar quality were we to purchase an insurance operation possessing it – to be far in excess of its historic carrying value. Under present accounting rules (with which we agree) this excess value will never be entered on our books. But I can assure you that it’s real. That’s one reason – a huge reason – why we believe Berkshire’s intrinsic business value substantially exceeds its book value.”
“…….but serious investors should understand the disparate nature of intangible assets. Some truly deplete over time, while others in no way lose value. For software, as a big example, amortization charges are very real expenses. The concept of making charges against other intangibles, such as the amortization of customer relationships, however, arises through purchase-accounting rules and clearly does not reflect reality. GAAP accounting draws no distinction between the two types of charges. Both, that is, are recorded as expenses when earnings are calculated – even though from an investor’s viewpoint they could not be more different.”
6) EBITDA is a very deceiving Valuation Parameter.
Warren Buffett advises that use of EBITDA (earnings before interest, tax, depreciation and amortization) in different valuation metrics with extreme care. Warren’s main concern arises from the fact that EBITDA does not deduct depreciation & amortization expenses from earning stating that these are non-real & non-cash expenses. However, Warren says that depreciation & amortization are real expenses, which must be factored in before doing any analysis.
“Depreciation charges, we want to emphasize, are different: Every dime of depreciation expense we report is a real cost. That’s true, moreover, at most other companies. When CEOs tout EBITDA as a valuation guide, wire them up for a polygraph test.”
“Our definition of (interest) coverage is pre-tax earnings/interest, not EBITDA/interest, a commonly used measure we view as seriously flawed.”
Also Read: How to do Financial Analysis of a Company?
7) Management is the most important aspect of any Investment.
Warren Buffett highlights the importance of honest & competent management for successfully running any business. Buffett says that any management which finds it difficult to avoid following market trends, may not give generate good returns for investors.
“At bottom, a sound insurance operation needs to adhere to four disciplines. It must (1) understand all exposures that might cause a policy to incur losses; (2) conservatively assess the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) set a premium that, on average, will deliver a profit after both prospective loss costs and operating expenses are covered; and (4) be willing to walk away if the appropriate premium can’t be obtained.
Many insurers pass the first three tests and flunk the fourth. They simply can’t turn their back on business that is being eagerly written by their competitors. That old line, “The other guy is doing it, so we must as well,” spells trouble in any business, but in none more so than insurance.”
Also Read: How to do Management Analysis of a Company?
(E) How Many Stocks To Buy
Warren believes in having a concentrated portfolio. He does not believe in buying a lot of stocks in his portfolio. He has always invested significant amounts in the stocks, about which he is convinced.
“I learned that GEICO was a terrific business and promptly put 65% of my $9,800 net worth into its shares”
“…..I found myself with more than 25% of BPL’s capital invested in a terrible business (Berkshire Hathaway) about which I knew very little….”
Even today, the “Big Four” investments: American Express, Coca-Cola, IBM and Wells Fargo, constitute 50% of his total stocks investments.
(F) When to Sell a Stock
1) Ideal Time to Sell: “Never”
The letter reiterates the stock investing philosophy of Warren Buffett and Berkshire Hathaway, when Charles Munger says:
“As an important matter of preferred conduct, Berkshire would almost never sell a subsidiary”
2) Exit Immediately, if a Company no longer fits in your Investment Parameters.
Warren Buffett has learnt that he should sell a stock immediately if these are any concerns about it failing to meet his investment criteria. He cites example of his delay in selling Tesco shares, which cost a lot of money to Berkshire shareholders.
“At the end of 2012 we owned 415 million shares of Tesco………… In 2013, I soured somewhat on the company’s then-management and sold 114 million shares, realizing a profit of $43 million. My leisurely pace in making sales would prove expensive. Charlie calls this sort of behavior “thumb-sucking.”
Warren cautions investors that they should not take bad information as one off instance. There are always bigger problems behind the curtains.
“In the world of business, bad news often surfaces serially: You see a cockroach in your kitchen; as the days go by, you meet his relatives.”
(G) Two Final Mantras
1) Admit Your Mistakes.
Warren Buffett’s experience shows that everyone is going to be proved wrong in future. Nevertheless, one can still make lot of money in stock markets, despite making a few mistakes, just as Buffett did. Therefore, investors should behave humble, admit mistake with open mind and try to learn from them.
Warren always admits to mistakes, shortcomings and inefficiencies to Berkshire shareholders.
“During the year, BNSF disappointed many of its customers. These shippers depend on us, and service failures can badly hurt their businesses….. But our service problems exceeded Union Pacific’s last year, and we lost market share as a result. Moreover, U.P.’s earnings beat ours by a record amount. Clearly, we have a lot of work to do.”
“…Others generate good returns in the area of 12% to 20%. A few, however, have very poor returns, the result of some serious mistakes I made in my job of capital allocation. I was not misled: I simply was wrong in my evaluation of the economic dynamics of the company or the industry in which it operates.
“An attentive investor, I’m embarrassed to report, would have sold Tesco shares earlier. I made a big mistake with this investment by dawdling.”
“Jack Ringwalt, the owner of NICO, was a long-time friend who wanted to sell to me – me, personally. In no way was his offer intended for Berkshire. So why did I purchase NICO for Berkshire rather than for BPL? I’ve had 48 years to think about that question, and I’ve yet to come up with a good answer. I simply made a colossal mistake.”
Warren always tries to keep his feet on the ground. He cautions investors that everyone is going to be proved wrong in future.
“Fortunately, my blunders normally involved relatively small acquisitions. Our large buys have generally worked out well and, in a few cases, more than well. I have not, nonetheless, made my last mistake in purchasing either businesses or stocks. Not everything works out as planned.”
“..Berkshire is perfectly positioned to allocate capital rationally and at minimal cost. Of course, form itself is no guarantee of success: We have made plenty of mistakes, and we will make more.”
2) Luck will play a part in the Returns from your Investments.
Charles Munger highlights the reasons for the great performance by Berkshire Hathaway over last 50 years. He does not forget to accept the role “Luck” has played in it. Luck will keep on playing its role in future performance of portfolio of Berkshire Hathaway and other investors like you & me!!
“ Why did Berkshire under Buffett do so well? Only four large factors occur to me:
(1) The constructive peculiarities of Buffett,
(2) The constructive peculiarities of the Berkshire system,
(3) Good luck, and
(4) The weirdly intense, contagious devotion of some shareholders and other admirers, including some in the press.
This concludes the current article in which I have summarized some of the investing lessons from Warren’s latest letter to Berkshire Hathaway shareholders written for the year 2014. 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.
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.