We Study Billionaires - The Investor’s Podcast Network - TIP521: Warren Buffett's Shareholder Letters

Starting point is 00:00:00 You're listening to TIP. Hey, everyone, welcome to the investors podcast. I'm your host, Clay Fink. On today's episode, I'm going to be talking about my biggest takeaways from reading Warren Buffett's shareholder letters. If you asked a lot of value investors, they would probably tell you that reading Buffett's letters is equivalent to getting an MBA on investing in business. Buffett graciously shared the investing in business practices he has used for decades to grow

Starting point is 00:00:29 the market value for Berkshire Hathaway shares by 20.1% annually from 1965 through 2021, which over that entire time period was a 3.6 million percent return relative to 30,000% for the S&P 500. Not only is there's so much to learn from Buffett with regards to investing, but there are many life lessons as well. This reminds me of my previous episode I released talking about Guy Spears' book, The Education of a Value Investor. Before we dive into the episode, I thought it would be a good opportunity to mention that TIP will be at the Berkshire Hathaway annual shareholder meeting this year on May 6th, 20203. We're hosting four free social events where you can meet Stig, Trey, and myself, as well as

Starting point is 00:01:16 socialized with the rest of the TIP audience members. I'm also doing a get-together prior to the meeting in front of the CenturyLink Center for the TIP members to meet and sit together at the annual meeting. Our social events are already getting a ton of attention, as many people have already registered and 150 people have joined our WhatsApp group chat. For details on our events, how to register, how to join the chat, be sure to check out the itinerary and the show notes if you're interested. For more details, you can also check out episode 500, where Stig and I discuss our events,

Starting point is 00:01:47 the Berkshire meeting, and common questions asked by the audience members about the Berkshire weekend. I am beyond excited for Berkshire weekend, as I always have to be able to be able to be able to a fun time there connecting with other like-minded investors. It's always one of the highlights of my year, and it will be even better getting to hang out with other TIP hosts as well as the audience members. Can't wait to see you all there. Without further delay, let's dive right into today's episode covering Warren Buffett's shareholder letters. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made

Starting point is 00:02:25 billionaires the most. We keep you informed and prepared for the unexpected. All right, so rather than taking the time to pull up each individual letter, luckily for me, Lawrence Cunningham put together a book called The Essays of Warren Buffett, where he compels all of his letters, so you aren't reading the same thing multiple times, and he makes it a little bit more digestible as he breaks the sections up into all these different topics that Warren has wrote about over the years. Berkshire's most important business is insurance, however, the conglomerate owns businesses across all of the United States economy ranging from phones, food, clothing, railroads, newspapers,

Starting point is 00:03:11 financial products, and much more. Some of these businesses are wholly owned businesses like Geico and Seas Candy, while others are partial ownership in publicly traded companies such as Apple and Coca-Cola. Buffett views Berkshire Hathaway as a partnership among him, Munger, and the other shareholders. And Buffett himself has virtually all of his net worth tied up in Berkshire Hathaway stock. Cunningham states that Buffett's economic goal is over the long term to maximize Berkshires per share intrinsic value by owning all or part of a diversified group of businesses that generate cash and earn above average returns. In achieving this goal, Buffett foregoes expansion just for the sake of expansion and foregoes divestment of businesses so long as they generate some cash

Starting point is 00:03:56 and have good management. Berkshire retains and reinvests earnings when doing so delivers at least proportional increases in per share market value over time. Berkshire uses debt sparingly and sells equity only when it receives as much value as the equity gives. If you go to Berkshire's website where all of his letters are at, you'll find that these go back all the way to 1977. And there are other sources that show his even earlier letters prior to 1977, but I wanted to take a look at what was shown on their website, too. His early letters were much shorter than they've been in more recent years, as his audience has continued to grown, but what amazes me is the level of consistency he has. Pulling up his 1977 shareholder letter, for example,

Starting point is 00:04:42 I see that he has public holdings in just seven companies, with nearly half of it being Geico preferred in common shares in Washington Post. And right after he lists his common stocks, he says that, 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 one that we can understand with favorable long-term prospects, operated by honest and competent people, and available at a very attractive price. We ordinarily make no attempt to buy equities for anticipated favorable stock price behavior in the short term. In fact, if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more

Starting point is 00:05:27 of a good thing at a better price. And if you read Buffett's more recent letters, you'll find him saying more or less the exact same thing. And this is a good reminder that good investment principles really never change. You'll see him say over and over again that he wants to own a number of great businesses that produce a lot of cash and they're run by honest and competent managers. In his most recent letter, which was for 2021, I love how even at the age he is, which is 92, he's just a really eloquent writer. He writes, quote, Charlie Munger, my long-time partner and I have the job of managing a portion of your savings. We are honored by your trust. Our position carries with it the responsibility to report to you what we would like to know

Starting point is 00:06:11 if we were the absentee owners and you were the manager. We enjoy communicating direct with you through this annual letter and through the annual meeting as well. Then he goes on to talk about Berkshire's business. Quote, Berkshire owns a wide variety of businesses, some in their entirety, some only in part. The second group largely consists of marketable common stocks of major American corporations. Additionally, we own a few non-US equities and participate in several joint ventures or other collaborative activities. Whatever our form of ownership, our goal is to have a meaningful investment in business,

Starting point is 00:06:47 businesses with both durable economic advantages and a first-class CEO. Please note particularly that we own stocks based on our expectation about their long-term business performance and not because we view them as vehicles for timely market moves. That point is crucial. Charlie and I are not stock pickers. We are business pickers. I make many mistakes. Consequently, our extensive collection of businesses include some enterprises that have

Starting point is 00:07:14 truly extraordinary economics, many others that enjoy just good economic characteristics, and a few that are marginal. One advantage of our common stock segment is that on occasion, it becomes easy to buy pieces of wonderful businesses at wonderful prices. That shooting fish in a barrel experience is very rare in negotiated transactions and never occurs in mass. It is also far easier to exit it from a mistake when it's been made in the marketable arena." Then a couple pages down is the section titled R4 Giants. The big four make up a good majority of Berkshire's value. The first is their collection of insurance businesses.

Starting point is 00:07:55 Regarding that segment, he says, The insurance business is made to order for Berkshire. The product will never become obsolete, and sales volume will generally increase along with both economic growth and inflation. Also, integrity and capital will forever be important. Our company can and will behave well. There are, of course, other insurers with excellent business models and prospects. Replication of Berkshire's operation, however, would be almost impossible.

Starting point is 00:08:23 Next, he lists Apple, which, as of his most recent 13F, Berkshire owns over $120 billion worth of Apple shares. Apple was just added to his portfolio in 2016, so it's a fairly new or recent holding relative to many of the other businesses. And it's grown substantially ever since then in terms of the number of shares they owned and the price of those shares increasing substantially as well. Buffett says that the look-through earnings for Apple that were attributable to Berkshire was a staggering $5.6 billion. Much of these earnings were used to issue dividends and conducts share repurches which Buffett says he applauds. Berkshire's third giant is BNSF, the railroad company he considers

Starting point is 00:09:04 to be an indispensable asset for America as well as for Berkshire. This portion had record earnings of $6 billion in 2021. Then the fourth and final giant is Berkshire Hathaway Energy, which also had record earnings in 2021 at $4 billion, and this is a 30-fold increase since the year 2000. Buffett stated that under David Sokol's and Greg Abel's leadership, BHE has become a utility powerhouse and the leading force in wind, solar, and transmission throughout much of the U.S.

Starting point is 00:09:36 And then Berkshire, of course, owns a number of other publicly traded stocks and wholly owned businesses he doesn't mention here. If you've read enough of Buffett's letters or listen to him at the shareholder meetings, you know that he's about the most honest and straightforward person that you could ever come across. If accounting earnings were artificially inflated up or down, then he would be the first to publicly state what is happening with those figures. When communicating business results, he simply tells it like it is. He doesn't want to lead on investors to purchasing shares in the company if the investors are being misled or if the price of the stock is trading far above its intrinsic value.

Starting point is 00:10:14 It's funny that as I was researching for this episode, I was also reading the book Influence by Robert Chaldingy, which is one of Charlie Munger's favorite and most recommended books. The book gives a master class on human psychology, and in the chapter covering how we react to authority, it mentions how Warren Buffett consistently reminds shareholders of all the mistakes he has made in the past. Chaldini writes that, rather than burying, minimizing, or papering over difficulties, which seems to be the tack taken all too frequently in other annual reports, Buffett demonstrates that he is first, fully aware of problems inside the company, and second, fully willing to reveal them. The emergent advantage is that when he then describes the formidable

Starting point is 00:10:57 strengths at Berkshire Hathaway, readers are ready to trust in them more deeply than before, because they know they are coming from a trustworthy communicator. Perhaps the clearest illustration of Buffett's Zell for demonstrating his transparency by admitting his shortcomings appeared in his annual report of 2016, a banner year in which his company's share price increased doubled that of the S&P 500 and in which there were no investing missteps to report. What did Bephut do to ensure that evidence of his openness and honesty would have remained top of mind for shareholders? On the report's second page of text, he noted a previous year's investing mistake that he described as the particularly egregious error of acquiring Dexter's shoe for $434 million in 1993.

Starting point is 00:11:45 Dexter's value promptly went to zero. Immediately thereafter, he detailed what he'd learned from the fiasco. He had not only misjudged the future worth of Dexter, but made the mistake of paying with Berkshire Hathaway stock, something he promised shareholders he would never do again. It's clear to me that Buffett knows more than how to be an impressively successful investor. He knows how to communicate impressively about being an impressively successful investor. So my big takeaway from reading this piece from Chaldeini's book is that since Buffett puts

Starting point is 00:12:16 so much emphasis on his mistakes, this leads to his shareholders and investors trusting him more because they believe that he will always be on the lookout for mistakes where bad things happening within Berkshire. Plus, Buffett's long-term success really just speaks for itself. As of recent years, Buffett has been repurchasing shares of Berkshire, which means that Buffett believes that Berkshire shares are actually undervalued. So if Buffett, who understands Berkshire better than anybody, believes that Berkshire shares are undervalued, then that is probably a pretty good entry price for long-term investors. And another thing I really appreciate it, about Buffett is that he writes these letters in a way that really anybody can understand. A lot of people

Starting point is 00:12:58 will write or talk in a way to try and impress others or try and show others how smart they are. And that is not what Buffett is about at all. He wants to communicate to shareholders in a clear and a straightforward way about covering how the business is performing and how Berkshire will operate for the years to come. And he's been extremely consistent with that approach and that message. One of the most critical pieces of the success of Buffett's investments is identifying able, honest, and diligent managers who act with integrity. He says that special attention especially should be paid to selecting a CEO because the standards for measuring a CEO's performance are inadequate and easy to manipulate. So it can be difficult for Buffett to measure the performance of a company's most important

Starting point is 00:13:45 worker. Plus, there's no one senior to the CEO. So if the CEO is acting irrationally or selfish how can you not expect others in the company to follow that CEO's lead? Buffett also wants to align management and shareholder interests. There have been many ways Wall Street has tried to do this. Oftentimes stock options are used, however, these may actually incentivize managers to try and increase stock prices in the near term or short term to maximize the value of those options rather than trying to maximize long-term shareholder value. Another issue that Buffett has with stock options is that by simply retaining and reinvesting earnings, managers can report annual earnings increases without hardly lifting a finger. Just about any manager could do that, but what you really

Starting point is 00:14:33 want to do is incentivize managers to be encouraged to improve real returns on capital. It can be a slight conflict of interest in that regard. However, Buffett does say that stock options can encourage the managers to think more like owners, but he doesn't believe it's the perfect tool to do so. He says, that shareholders of the company are exposed to the downside risks of, you know, suboptimal capital deployment and option holders aren't really exposed to that in the same manner. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord,

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Starting point is 00:19:04 That's Shopify.com slash WSB. All right. Back to the show. One of Buffett's best solutions to selecting the right managers is to try and select someone who will just do the right thing, even if poor incentives happen to be in place. Managers who act honestly and act with integrity don't need much overwatch from the board or from Buffett. The CEOs at Berkshire's various operating companies enjoy a unique position in corporate America.

Starting point is 00:19:35 Buffett gives them a simple set of rules. That's to run the business as if they were the sole owners. It is the only asset they own, and they can never sell it to anyone in 50 years. This simple framework is Buffett's way of telling them to act in the best interest of long-term shareholders. And this is an idea that's pretty alien to a lot of Wall Street. As far as Berkshire's own managers, Warren says that, quote, most of their directors have a major portion of their net worth in the company.

Starting point is 00:20:04 We eat our own cooking. Charlie's family has a majority of their net worth in Berkshire shares. I have more than 99%. 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. So not only does Buffett want to own stock in companies where managers own a lot of shares in the company, he acts in that manner himself essentially having his entire net worth in Berkshire Hathaway. To help show Buffett's admiration for the managers he works with, here's what he wrote in his 1988 shareholder letter.

Starting point is 00:20:41 The earnings achieved by our operating businesses are superb, whether measured on an absolute basis or against those of their competitors. For that, we thank our operating managers. You and I are fortunate to be associated with them. At Berkshire, associations like these last a long time. We do not remove superstars from our lineup merely because they have attained a specific age, whether that be the traditional 65 or the 95 reached by Mrs. B. on the eve of Hanukkah in 1988.

Starting point is 00:21:11 Superb managers are too scarce a resource to be discarded simply because a cake gets crowded with candles. Moreover, our experience with newly minted MBAs has not been that great. Their academic records always look terrific and the candidates always know exactly what to say. But too often, they are short on personal commitment to the company and general business savvy. It's difficult to teach a new dog old tricks. Later on in that letter, he talked about his purchase of Borsheims, which is a jewelry store

Starting point is 00:21:41 out of Omaha. I can assure you that those who put their trust in Ike Friedman and his family will never be disappointed. The way in which we purchased our interest in their business is the ultimate testimonial. Borsheims has no audited financial statements. Nevertheless, we didn't take inventory, verify receivables, or audit the operation in any way. Ike simply told us what was so, and on that basis, we drew up a one-page contract and wrote a large check. Borsheim's new links to Berkshire will change nothing in the way that business is run. All members of the Friedman family will continue to operate just as they have before. Charlie and I will stay on the sidelines where we belong.

Starting point is 00:22:22 And when we say all members, the words have real meaning. Mr. and Mrs. Friedman at 88 and 87, respectively, are in the store daily. The wives of Ike, Allen, Marvin, and Donald all pitch in at busy times, and a fourth generation is beginning to learn the ropes. It is great fun to be in a business with people you have long admired. The freedmen's like the Blumpkins have achieved great success because they have deserved success. Both families focus on what's right for the customer, and that inevitably works out well for them also. We couldn't have better partners. So as many are familiar with Buffett's early investment style of buying something cheap, it's pretty cool to see how much emphasis he puts on purchasing companies

Starting point is 00:23:05 with quality management and how seriously he takes the idea of treating the managers and his shareholders like partners. He not only treats his shareholders like partners, but he encourages his shareholders to think the same way. He says, 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. When you look at all Buffett's letters, you'll find that the first thing he shows is how much Berksler's value has moved over the year

Starting point is 00:23:49 and what that performance has been since Buffett took hold of the company. In the early days, he would show how much the company's book value had changed from year to year, because that was a good measure to show how much the stock and the company was increasing in value over time. However, he eventually transitioned to just show the increase in the market value of Berkshire rather than the book value because of the decreased importance of book value over time. In the economy of the past, with steel mills and manufacturing companies, book value was highly relevant to determining the value of a business. However, with the continued rise of things like intangible assets, which are increasingly difficult to put a value on, this

Starting point is 00:24:27 makes book value less and less relevant over time. Thus, it was just recently that Buffett started putting in the increase in the market value of the shares rather than book value, and then showed the increase in the S&P 500 as well. Buffett's pretty quick to point out that it's the increased operating earnings of the businesses and that capital being redeployed effectively is what's going to drive the continued growth of Berkshire's intrinsic value. In his 1992 letter, Buffett noted that him and Charlie aimed to grow intrinsic value by at least 15% annually. And they were quite certain that they were going to be able to beat the S&P 500 over the decade ahead, which isn't something you'd hear them say today because of the much larger capital base they're operating from.

Starting point is 00:25:07 I recall from either the 2017 or 2018 annual meeting I attended, he said he expected Berkshire to compound at roughly 10% per year, which is still quite remarkable given their size today. And to achieve that 15% target in the growth of the intrinsic value that they said in the early 90s, he knew he'd have to grow earnings by 15% as well. So in 1992, earnings were $604 million. And if you compound that at 15% annually, this would need to grow to $1.8 billion by the year 2000 to meet that goal. He says that for us to get there, our operating subsidiaries and investees must deliver excellent performances, and we must exercise some skill in capital allocation as well. We cannot promise to achieve the $1.8 billion target. Indeed, we may not even come close to it,

Starting point is 00:25:57 but it does guide our decision-making. When we allocate capital today, we are thinking about what will maximize look-through earnings in 2000. So I think there's a little bit of a subtle difference here in how Warren presents potential future growth versus how a lot of other managers do it. And this isn't me trying to say that these managers are bad people. I think it goes to show how honest and straightforward Warren tries to be with these letters. So Warren essentially says that they intend to try and grow Berkshires look through earnings by at least 15% annually, and they may definitely fail, but that's what they're going to try and do. Whereas what I see with some other managers is that they'll project earnings to grow by 15% per year over the next five years, and

Starting point is 00:26:40 they'll state how confident they are in their ability to do that. So they're really trying to to sell shareholders on these projections rather than simply telling them what they are targeting for growth and earnings. Buffett believes that projecting these earnings with confidence over the short run is oftentimes a fool's errand, and investors should be skeptical of managers who act confident that they know where earnings will be next year or next quarter. Managers shouldn't state their confidence in high growth rates because a very small percentage of large businesses are able to end up achieving a high growth rate of, say, 15% over the long term. Buffett says that Charlie and I tend to be leery of companies run by CEOs who woo investors

Starting point is 00:27:20 with fancy predictions. A few of these managers prove prophetic, but others will turn out to be optimists or even charlatans. Unfortunately, it's not easy for investors to know in advance which species they are dealing with. Another aspect I find interesting is how Buffett thinks about his holding period and achieving those returns. You'd think that if a company became overvalued, then Buffett would be willing to sell and overvalued company and allocated to something that's undervalued. But that's not really the

Starting point is 00:27:49 way he approaches it. During the tech bubble, Warren and Charlie knew that Coca-Cola was likely overvalued and the stock was 10x above their cost bases at the time, and it was their largest equity holding at the end of 1999 at over $11 billion, but they decided not to sell it. On this topic, Buffett wrote, quote, you should be fully aware of one attitude, Charlie and I share that hurts our financial performance. Regardless of price, we have no interest at all in selling any good businesses that Berkshire owns. We are also very reluctant to sell subpar businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations. We hope not to repeat the capital allocation mistakes that led us to

Starting point is 00:28:34 such subpar businesses. And we react with great caution to suggestions that our poor businesses can be restored to satisfactory profitability by major capital expenditures. The projections will be dazzling and the advocates sincere, but in the end, major additional investment in a terrible industry usually is about as rewarding as struggling in quicksand. Based on Buffett's past actions, this leads me to believe that if he is holding a great company that produces a lot of cash, then he will lean towards not selling it,

Starting point is 00:29:07 even if he believes the company is overvalued. However, if his opinion about a company changes or he sees more risk in a company than he originally thought, then he may end up selling out of that position. For example, in 2017, Buffett stated that he was wrong about his thesis on IBM. So he decided to gradually sell out of that position as they faced more competition than he originally thought. And then he was also analyzing Apple and determined that he was much more certain and optimistic on Apple's future.

Starting point is 00:29:35 So during that year, he had been selling out of IBM and accumulating shares. of Apple, which in hindsight was a very good move for him. Now, I think a big reason for this approach is because Buffett wants to be known as holding wholly owned companies indefinitely. I think a big reason that Buffett wants to be known as holding these wholly owned companies forever is because people who build a business oftentimes care about who the business is going to be sold to. If you spent your whole life building a company up, you probably don't want to sell your

Starting point is 00:30:04 company to someone who wants to get involved in a business, make unnecessary changes. and then try and flip it. A lot of business people would rather sell to someone like Buffett who let the managers do their job and don't intend to ever sell the business. And I think that Buffett wants to try and portray himself as that type of investor to attract those quality businesses with quality managers.

Starting point is 00:30:27 Buffett says that most business owners spend the better part of their lifetimes building their businesses. By experiences built upon endless reputation, they sharpen their skills in merchandising, purchasing, personnel selection, etc. It's a learning process and mistakes made in one year often contribute to competence and success in succeeding years. In contrast, owner-managers sell their business only once, frequently in an emotionally charged environment with a multitude of pressures coming from different directions. Often, much of the pressure comes from brokers whose compensation is contingent upon the sale,

Starting point is 00:31:02 regardless of the consequences for the buyer and the seller. The fact that the decision is so important, both financially and personally, this can make the owner more prone to error. And mistakes made in the once-in-a-lifetime sale of a business are not reversible. Price is very important, but often is not the most critical aspect of the sale. If you should decide to sell, I think Bershier-Hathaway offers some advantages that most other buyers do not. Then he describes how most buyers are either companies in a similar industry trying to acquire a business in their industry to create synergies, or the other.

Starting point is 00:31:37 type of buyer is a financial maneuver oftentimes using leverage in the purchase to try and resell the business later. If the sole motive of the present owners is to cash in their chips and put the business behind them, either type of buyer that I've just described will work for them. But if the seller's business represents the creative work of a lifetime and forms an integral part of their personality and sense of being, buyers of either type really have serious flaws. Berkshire is another kind of buyer, and a rather unusual one. We buy to keep, but we don't have and don't expect to have operating people in our parent organization. When we buy a business, the sellers go on running it just as they did before the sale. We adapt to their methods rather than vice versa. And I had just

Starting point is 00:32:25 talked about how Buffett wants the managers of the companies he owns to have skin in the game. For the wholly owned businesses, he says that he wants the operating members of the family to retain 20% interest in the business. Then he goes on to say that he does get involved in capital allocation decisions as well as the compensation and selection of the top managers. The purchases that Berkshire makes are with cash and no businesses are ever used as collateral in any loan. Buffett wants to buy from someone who truly cares about their business and values the blood, sweat, and tears that they've put into it. And he also wants someone that really cares about who they're selling the business too. When you find you find out,

Starting point is 00:33:05 Find a family or a group of managers who care intensely about the business, many good qualities are likely to be found in that business that Warren would once as well. Regarding Berkshire Hathaway's shareholder base, I couldn't find which letter this was pulled from, but in one of them, Buffett stated, in some ways our shareholder group is an unusual one, and this affects our manner of reporting to you. For example, at the end of each year, about 98% of the shares outstanding are held by people who also were shareholders at the beginning of the year. Therefore, in our annual report, we build upon what we have told you in previous years instead of restating a lot of the

Starting point is 00:33:45 material. Furthermore, perhaps 90% of our shares are owned by investors for whom Berkshire is their largest security holding, very often far and away the largest. Many of these owners are willing to spend a significant amount of time with the annual report, and we attempt to provide them with the same information we would find useful if the roles were reversed, end quote. I've been to a number of Berkshire's annual meetings, but just reading these numbers further reminds me that his shareholder base just has so much trust and faith in what Warren and Charlie are doing. Warren even says himself that he isn't trying to maximize the price at which Berkshire shares trade. Instead, he'd rather the stock trades roughly around its intrinsic value so that shareholders reap the rewards of the

Starting point is 00:34:32 underlying business during that holding period. He also wants his shareholders to act like long-term business owners. He says that our goal is to attract long-term owners who at the time of purchase have no timetable or price target for sales, but plan instead to stay with us indefinitely. Of course, some Berkshire owners will need or want to sell from time to time, and we wish for good replacements who will pay them a fair price. Therefore, we try through our policies, performance, and communications to attract new shareholders who understand our operations, share our time horizons, and measure us as we would measure ourselves, end quote. Buffett's goal with the letters is not only to be a teacher, but also communicate in an honest way the information they would want to know if they were

Starting point is 00:35:17 shareholders themselves and the company. I've had a number of episodes covering Buffett's investment philosophy, but it's worth repeating investing maxims and fundamentals. Buffett said that he purchased a substantial position in the Washington Post in mid-1973 at a price not more than one-fourth of the true underlying value of the enterprise. Quote, calculating the price-to-value ratio required no unusual insights. Most security analysts, media brokers, and media executives would have estimated the Washington Post's intrinsic business value to be around 400 to 500 million, just as we did. And its $100 million stock market valuation was published, daily for all to see. Our advantage, rather, was attitude as we had learned from Benjamin Graham

Starting point is 00:36:03 that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values, end quote. Then he goes on to talk about how academics say there's no use in trying to find bargains in the market because the market is fully efficient, to which Buffett states, we are enormously indebted to those academics. What could be more advantageous in an intellectual contest, whether it be bridge, chess, or stock selection? Then, to have opponents who believe that thinking is a waste of energy, end quote. He then mentioned a farm he purchased in his thought process on how much income that farm would produce over the years. Then he listed a few bullet points of his fundamentals of investing.

Starting point is 00:36:48 First is, you don't need to be an expert in order to achieve satisfactory investment returns. But if you aren't, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don't swing for the fences. When promised quick profits respond with a quick no. Second is focus on the future productivity of the asset you are considering. If you don't feel comfortable making a rough estimate of the asset's future earnings, just forget it and move on.

Starting point is 00:37:17 Third, if you focus on the prospective price change of a contemplated purchase, you are speculating. There's nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so. Half of all coin flippers will win their first toss. None of those winners has an expectation of profit if he continues to play that game. And the fact that a given asset has appreciated in the recent past is never a reason to buy it. Fourth, he says, with my two small investment properties, I thought only of what the properties would produce and cared not at all about their daily valuations. Games are won by players who focus on the playing field, not by those whose eyes are glued to the scoreboard.

Starting point is 00:38:03 If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays. Fifth and finally, forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up and customers now expect proof of security just to do business. That's why VANTA is a game changer. VANTA automates your compliance process and brings compliance, risk, and customer trust together on one AI-powered platform. So whether you're prepping for a stock two or running an enterprise GRC program, VANTA

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Starting point is 00:42:01 I love this quote from him. A climate of fear is your friend when investing. A euphoric world is your enemy. And it stands so true today as everybody is expecting markets to crash, which probably it means it's a pretty good time to go shopping while the majority of other investors are skeptical and hesitant. He says, quote, during the extraordinary financial panic that occurred in late 2008, I never gave a thought to selling my farm or selling my New York's real estate, even though a severe recession was clearly brewing. And if I had owned 100% of a solid business with good

Starting point is 00:42:36 long-term prospects, it would have been foolish for me to even consider dumping it. So why would I have sold my stocks that were a small participation in wonderful businesses. It's true that any one of them might eventually disappoint, but as a group, they were certain to do well. Could anyone really believe the Earth was going to swallow up the incredible productive assets and unlimited to human ingenuity existing in America? When Charlie and I buy stocks, which we think of small portions of businesses, our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out or more. If the answer is yes, we will buy the stock or business if it sells at a reasonable

Starting point is 00:43:20 price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings, which is usually the case, we simply move on to other prospects. In studying the work of Buffett, I've personally embraced this idea that I don't need to have an opinion on every single business. If I'm not confident that the business will be able to grow over the next five years, then I just stop my analysis there and not even have to develop an opinion on it because I can focus my efforts elsewhere. Of course, Buffett doesn't recommend others to purchase individual stocks. For those that don't have an interest in picking stocks and doing all the necessary research, he recommends simply buying a low-cost index fund that owns a diversified set

Starting point is 00:44:03 of American businesses, such as the S&P 500. Additionally, you'll want a dollar cost average into those businesses over time and hold them for the long term. He says, quote, by periodically investing in an index fund, the no-nothing investor can actually outperform most investment professionals. Paradoxically, when dumb money acknowledges its limitations, it ceases to be dumb. On the other hand, if you are a know-something investor, able to understand business economics, and to find five to ten sensibly prided, companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite

Starting point is 00:44:54 rather than simply adding that money to his top choices, the businesses he understands best and present the least risk, along with the greatest profit potential, end quote. Buffett practices what he preaches here, as at the time of his Q3-2020-13F, he has over 40% of his stock portfolio in Apple, and his top five holdings comprise of almost 75% of his portfolio. I also love how, in order to increase his win rate with his investments in certainty of making money, Buffett wants to own businesses that are unlikely to experience major change. He says that, quote, the reason for this is simple. Making either type of purchase, We are searching for operations that we believe are virtually certain to possess enormous competitive

Starting point is 00:45:42 strength 10 or 20 years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek. I should emphasize that as citizens, Charlie and I welcome change, fresh ideas, new products, innovative processes, and the like, cause our country's living standards to rise. And that's clearly good. As investors, however, our reaction to a fermenting industry is much like our attitude towards space exploration. We applaud the endeavor, but prefer to skip the ride. Buffett doesn't just want certainty within a business, though. He's also well aware that he needs to pay a fair price for these certainties, as he states,

Starting point is 00:46:21 investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid. Then he goes on to talk about scenarios where the management team gets sidetracked. A far more serious problem occurs when the management of a great company gets sidetracked and neglects its wonderful base business while purchasing other businesses that are so-so or worse. When that happens, the suffering of investors is often prolonged. Unfortunately, that is precisely what transpired years ago at Coke. Would you believe that a few decades back, they were growing shrimp at Coca-Cola. Loss of focus is what most worries Charlie and me, when we contemplate

Starting point is 00:47:07 investing in a business that is outstanding. All too often, we've seen value stagnate in the presence of hubris or of boredom that caused the attention of managers to wander. That's not going to happen again at Coca-Cola, however, not given current and prospective managements, end quote. Expanding on that idea that we should stick with highly certain businesses that are simple to understand, Warren says, After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers. The finding may seem unfair,

Starting point is 00:47:55 but in both business and investments, it is usually far more profitable to stick with with the easy and the obvious than it is to resolve the difficult. On occasion, tough problems must be tackled. In other instances, a great investment opportunity occurs when a marvelous business encounters a one-time huge but solvable problem, as was the case many years back at both American Express and Geico. Overall, we've done better by avoiding dragons than slaying them. I think this is both a great investment and business lesson.

Starting point is 00:48:26 If you were one that wanted to start a business, I think addressing a sales, I think addressing a simple need is oftentimes much more profitable than solving something entirely new and complex. A lot of people see entrepreneurs on Shark Tank trying to innovate and create something new and try and change the world. Oftentimes, the most reliable and the most profitable path to being a successful entrepreneur is just to take a business model that already exists, a business that's fairly simple, fairly straightforward, and create a business that improves on that model in some way or add your own twist to it. I bet that if you met a wealthy entrepreneur in your city and if you're outside of Silicon Valley, I'd venture to guess that they became

Starting point is 00:49:09 wealthy through a boring or non-sexy business such as lawn care or vehicle servicing. Entrepreneurs addressing a basic need are like Buffett and that they are hitting consistent singles rather than swinging for the fences. I also really take to heart Buffett's advice on debt. He knows that Berkshire's financial results very likely would have been significantly better had he utilized debt in order to invest more and more over the years. But, however, that slim chance that things go the other way make debt not worth it because you're risking financial catastrophe. He says that unquestionably, some people have become very rich through the use of borrowed money.

Starting point is 00:49:48 However, that's also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you're clever and your neighbors get envious, but leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And to repeat, as we all learned in third grade and some relearned in 2008, any series of positive numbers, however impressive the numbers may be, evaporates when it's multiplied by a single zero. History tells us that leverage all too often produces zeros, even when it's employed by very smart people. This story reminds me of Jesse Livermore. He was known as one of the greatest

Starting point is 00:50:30 traders to ever live, yet he continually took on risk throughout his life and most of the time successfully made a ton of money. He had become one of the richest people in the world by profiting from the crash of the Great Depression and the stock market. In inflation-adjusted terms, he would have been a billionaire at that time. Throughout Livermore's entire life, his net worth would skyrocket up and then come crashing down, and he even declared bankruptcy a number of times throughout his life. Just after the Great Depression, Livermore ended up taking his own life as he had accumulated debt that exceeded the assets he owned, reminding us that even the smartest people in the world can get out over their skis with leverage and then

Starting point is 00:51:12 just take unnecessary risk. Leverage is not only dangerous for individuals, but it can be just as dangerous for businesses as well. Companies with large debts often assume that they will be able to refinance that debt on maturity, but there are times when that's not really possible, either when the company is going through issues themselves or there's just a shortage of credit in the overall markets, such as what we saw in the great financial crisis. Buffett says that, borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that's all is noticed. Even a short absence of credit can bring a company to its knees.

Starting point is 00:51:53 In September of 2008, in fact, its overnight disappearance in many sectors of the economy came dangerously close to bringing our entire country to its knees. And just reading that, it reminds me in my previous episode covering Guy Spear, where he talked about how CarMax was really dependent on credit. And when they couldn't get credit during the great financial crisis, their business and their stock just totally cratered. Buffett always keeps ample amounts of cash within Berkshire. First, he needs to be able to pay off any large insurance claims within the business, and second is so he can seize investment opportunities when chaos strikes

Starting point is 00:52:29 and fear becomes widespread. Following the bankruptcy of Lehman Brothers in 2008, this allowed Buffett to invest over $15 billion in 25 days into the markets. Transitioning a bit, one of the biggest lessons from Buffett I've learned in recent years is the importance of share repurchases. One might believe that share repurchases are unproductive because that's money that could otherwise be spent on the business. However, share repurchases have a tremendous benefit to shareholders. Here's Buffett's take on share repurchases, quote, the companies in which we have our largest investments have all engaged in significant stock repurchases at times when wide discrepancies existed between price and value. As shareholders,

Starting point is 00:53:15 we find this encouraging and rewarding for two important reasons, one that is obvious and one that is subtle and not always understood. The obvious point involving basic arithmetic, major share repurchases at prices well below per share intrinsic business value, immediately increases in a highly significant way that value. When companies purchase their own stock, they often find it easy to get $2 of present value for one. Corporate acquisition programs almost never do well, and in a discouragingly large number of cases fail to get anything close to $1 of value for each $1 expended. The other benefit of share repurchases is less subject to precise measurement, but can be

Starting point is 00:54:00 really important over time. By making repurchases when a company's market value is well below its business value, Management clearly demonstrates that it is taking actions that enhance the wealth of shareholders, rather than taking actions that expand management's domain, but that do nothing or even harm shareholders. Seeing this, shareholders and potential shareholders increase their estimates of future returns from the business. This upward revision in turn produces market prices more in line with intrinsic business value. These prices are entirely rational. Investors should pay more for a business that is lodged in the hands of a manager with demonstrated pro-shareholder leanings

Starting point is 00:54:42 than for one in the hands of a self-interested manager marching to a different drum. I cannot overstate how important I believe share repurchases are. When I'm analyzing a business, I think is undervalued that is producing a lot of cash, and I see that managers are buying back a lot of shares. That gives me further vindication that the stock is truly undervalued because management is buying back shares themselves. But another added bonus is that management cares about the shareholder interest because they are redirecting a lot of that cash that the business produces and sending it right back to the shareholders

Starting point is 00:55:15 through those repurchases. I recently took a position in a company that has seen their sales and earnings increase over time, and while the stock is traded down in recent months, management has been aggressively buying back shares as well as increasing their dividends. This gives me further vindication because as long as the business is good and the fundamentals remain strong, then I almost see share repurchases as putting a floor on the stock price, because eventually the market's going to realize the stock is undervalued as buybacks continue to be high relative to the stock price, then new buyers will come in and eventually push the stock

Starting point is 00:55:49 price up. Or to look at it another way, I think the sell side or people selling the stock eventually becomes exhausted, and there's simply no one left to sell the shares at these low prices. Historically, Buffett hasn't repurched his own shares in Berkshire Hathaway, but has changed that more recently. It was in 2020, Berkshire repurchase $24 billion in their own shares and then $27 billion in 2021. And that slowed down drastically in 2022 as well, and Buffett started to see better opportunities elsewhere.

Starting point is 00:56:20 Buffett being one of the best capital allocators on the planet, when he is heavily repurchasing shares, it's a pretty good sign that he believes the stock is undervalued. Otherwise, he wouldn't do it. He believes that shareholder value is destroyed when shares are repurchase, at a price above their intrinsic value. Another odd thing to consider with Berkshire repurchasing shares is that the volume of shares traded relative to the market value of those shares, it's very low since not many people are buying and selling these shares.

Starting point is 00:56:49 So if a big buyer like Buffett comes in with billions of dollars, it might take him quite a bit of time to buy back those shares. And he'll really move the market quite a bit if he brings in a lot of money. And then I wanted to round out today's episode by talking about Burkshire, Berkshire successors. This topic has been quite popular for many years as Buffett and Munger have approached the end of their own tenure. Buffett says that, quote, choosing the right CEO is all important and is subject that commands much time at Berkshire board meetings. Managing Berkshire is primarily a job of capital allocation, coupled with selection and retention of outstanding

Starting point is 00:57:28 managers to captain or operating subsidiaries. Obviously, the job also requires the replacement of a subsidiary CEO when that is called for. These duties require Berkshire CEO to be a rational, calm, and decisive individual who has a broad understanding of business and good insights into human behavior. It's important as well that he knows his limits. Character is crucial. A Berkshire CEO must be all in for the company, not for himself. He can't help but earn money far in excess of any possible need for it.

Starting point is 00:58:01 But it's important that neither ego nor avarice motivate him to reach for pay matching his most lavishly compensated peers, even if his achievements far exceed theirs. A CEO's behavior has a huge impact on managers down the line. If it's clear to them that shareholder interests are paramount to him, they will, with few exceptions also embrace that way of thinking. My successor will need one other particular strength, the ability to fight off the ABCs of business decay, which stands for arrogance, bureaucracy, and complacency. When these corporate cancers come to light, even the strongest of companies can falter.

Starting point is 00:58:41 The examples available to prove the point are plentiful. So this excerpt is well in line with the management principles that Buffett is looking for that I talked about on the episode I did covering Warren Buffett's 12 investment principles. In that episode, I talked about how Buffett wants to invest with managers who are honest and competent, as well as good capital allocators in acting in shareholders' best interest. Also, he wants to invest with managers who are candid with shareholders. They'll talk about the business exactly as it is rather than trying to be dishonest, making accounting maneuvers to try and make the business look better than it is.

Starting point is 00:59:16 And finally, he wants to invest with managers who resist the institutional imperative and who are really able to think for themselves and come to their own conclusions rather than just follow what all the other CEOs are doing. Today, Todd Combs and Ted Wechler manage a smaller portion of Berkshire's overall portfolio. Buffett said that these two people were the only ones they could find who read as much as they did. In one interview, Todd Combs was asked what his typical day looks like at Berkshire, and he said he gets to the office around 7 or 8 in the morning, and then he reads until 7 or 8 at night.

Starting point is 00:59:49 So definitely wired similarly to Buffett and that he's just a learning machine, always trying to bring in new information. So I think that Berkshire will inevitably be in really good hands once Warren and Charlie passed the torch to the next managers. All right, that wraps up today's episode. If you don't already, be sure to click follow on the podcast app you're on so you can get notified of all of our future episodes coming out. Also, if you enjoyed this episode, I would really, really appreciate it.

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We Study Billionaires - The Investor’s Podcast Network - TIP521: Warren Buffett's Shareholder Letters

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