Every Investing Insight From Warren Buffet (1977-2017)
Insurance & People - Insurance companies offer standardised policies which can be copied by anyone. Their only products are promises. It is not difficult to be licensed, and rates are an open book. There are no important advantages from trademarks, patents, location, corporate longevity, raw material sources, etc., and very little consumer differentiation to produce insulation from competition.
It is commonplace, in corporate annual reports, to stress the difference that people make. Sometimes this is true and sometimes it isn’t. But there is no question that the nature of the insurance business magnifies the effect which individual managers have on company performance.
Our experience has been that pro-rata portions of truly outstanding businesses sometimes sell in the securities markets at very large discounts from the prices they would command in
negotiated transactions involving entire companies.
Investing - We paid less than 100 cents on the dollar for the best company in the business, when far more than 100 cents on the dollar is being paid for mediocre companies in corporate transactions. And there is no way to start a new operation - with necessarily uncertain prospects - at less than 100 cents on the dollar.
Operating Performance - On this basis, we had a reasonably good operating performance in 1979 - but not quite as good as that of 1978 - with operating earnings amounting to 18.6% of beginning net
worth. Earnings per share, of course, increased somewhat (about 20%) but we regard this as an improper figure upon which to focus. We had substantially more capital to work with in 1979
than in 1978, and our performance in utilizing that capital fell short of the earlier year, even though per-share earnings rose. “Earnings per share” will rise constantly on a dormant savings
account or on a U.S. Savings Bond bearing a fixed rate of return simply because “earnings” (the stated interest rate) are continuously plowed back and added to the capital base. Thus, even a “stopped clock” can look like a growth stock if the dividend payout ratio is low.
ROIC - The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.
Inflation - the inflation rate plus the percentage of capital that must be paid by the owner to transfer into his own pocket the annual earnings achieved by the business (i.e., ordinary income tax on dividends and capital gains tax on retained earnings) - can be thought of as an “investor’s misery
index”. When this index exceeds the rate of return earned on equity by the business, the investor’s purchasing power (real capital) shrinks even though he consumes nothing at all. We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity.
Gains In Purchasing Power - Only gains in purchasing power represent real earnings on investment. If you (a) forego ten hamburgers to purchase an investment; (b) receive dividends which, after tax, buy two hamburgers; and © receive, upon sale of your holdings, after-tax proceeds that will
buy eight hamburgers, then (d) you have had no real income from
your investment, no matter how much it appreciated in dollars.
You may feel richer, but you won’t eat richer.
Indexing - Indexing is the insulation that all seek against inflation. But the great bulk (although there are important exceptions) of corporate capital is not even partially indexed. Of course,
earnings and dividends per share usually will rise if significant earnings are “saved” by a corporation; i.e., reinvested instead of paid as dividends. But that would be true without inflation. A thrifty wage earner, likewise, could achieve regular annual increases in his total income without ever getting a pay increase - if he were willing to take only half of his paycheck in cash (his wage “dividend”) and consistently add the other half (his “retained earnings”) to a savings account. Neither this high-
saving wage earner nor the stockholder in a high-saving corporation whose annual dividend rate increases while its rate of return on equity remains flat is truly indexed.
For capital to be truly indexed, return on equity must rise, i.e., business earnings consistently must increase in proportion to the increase in the price level without any need for the business to add to capital - including working capital - employed. (Increased earnings produced by increased investment
don’t count.) Only a few businesses come close to exhibiting this ability. And Berkshire Hathaway isn’t one of them.
Buying Great Businesses - Regardless of the impact upon immediately reportable earnings, we would rather buy 10% of Wonderful Business T at X per share than 100% of T at 2X per share. Most corporate managers prefer just the reverse, and have no shortage of stated
rationales for their behavior.
Many managements apparently were overexposed in impressionable childhood years to the story in which the imprisoned handsome prince is released from a toad’s body by a kiss from a beautiful princess. Consequently, they are certain their managerial kiss will do wonders for the profitability of Company Target).
Such optimism is essential. Absent that rosy view, why else should the shareholders of Company Acquisitor want to own an interest in T at the 2X takeover cost rather than at the X market price they would pay if they made direct purchases on their own?
In other words, investors can always buy toads at the going price for toads. If investors instead bankroll princesses who wish to pay double for the right to kiss the toad, those kisses had better pack some real dynamite. We’ve observed many kisses but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses - even after their corporate backyards are knee-deep in unresponsive toads.
High Prices - For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.
Poor Industries - The projections will be dazzling - the advocates will be sincere - but, in the end, major additional investment in a terrible industry usually is about as rewarding as struggling in quicksand.
Last year, in discussing how managers with bright, but adrenalin-soaked minds scramble after foolish acquisitions, I quoted Pascal: “It has struck me that all the misfortunes of men spring from the single cause that they are unable to stay quietly in one room.”
Stock Buybacks - The other benefit of repurchases is less subject to precise measurement but can be fully as important over time. By making repurchases when a company’s market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management’s domain but that do nothing
for (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 than for one in the hands of a self-interested manager marching to a different drummer. (To make the point extreme, how much would you pay to be a minority
shareholder of a company controlled by Robert Wesco?)
Family Businesses - The key to a successful family business - All members of the family: (1) apply themselves with an enthusiasm and energy that would make Ben Franklin and Horatio Alger look like dropouts; (2) define with extraordinary realism their area of special competence and act decisively on all matters within it; (3) ignore even the most enticing propositions
failing outside of that area of special competence; and, (4) unfailingly behave in a high-grade manner with everyone they deal with. (Mrs. B boils it down to “sell cheap and tell the truth”.)
Large Cap Growth - And an iron law of business is that growth eventually dampens exceptional economics. just look at the records of high-return companies once they have amassed even $1 billion of equity capital. None that I know of has managed subsequently, over a ten-year period, to keep on earning 20% or more on equity while reinvesting all or substantially all of its earnings. Instead, to sustain their high returns, such companies have needed to shed a lot of capital by way of either dividends or repurchases of stock. Their shareholders would have been far better off if all earnings could have been reinvested at the fat returns earned by these exceptional businesses. But the companies simply couldn’t turn up enough high-return opportunities to make that possible.
Price Swings - Wild swings in market prices far above and below business value do not change the final gains for owners in aggregate; in the end, investor gains must equal business gains
Talent - Usually the managers came with the companies we bought, having demonstrated their talents throughout careers that spanned a wide variety of business circumstances. They were managerial stars
long before they knew us, and our main contribution has been to not get in their way. This approach seems elementary: if my job were to manage a golf team - and if Jack Nicklaus or Arnold
Palmer were willing to play for me - neither would get a lot of directives from me about how to swing.
Working with people who cause your stomach to churn seems much like marrying for money - probably a bad idea under any circumstances, but absolute madness if you are already rich.
Remarkable Business - Our premium of business value to book value has widened for two simple reasons: We own some remarkable businesses and they are run by even more remarkable managers.
You have a right to question that second assertion. After all, CEOs seldom tell their shareholders that they have assembled a bunch of turkeys to run things. Their reluctance to do so makes for some strange annual reports. Oftentimes, in his shareholders’ letter, a CEO will go on for pages detailing
corporate performance that is woefully inadequate. He will nonetheless end with a warm paragraph describing his managerial comrades as “our most precious asset.” Such comments sometimes
make you wonder what the other assets can possibly be.
Moats - Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten
years ago. That is no argument for managerial complacency. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously
these opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever
shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns.
Borrowing - Really good businesses usually don’t need to borrow.
Franchises - The record of these 25 companies confirms that making
the most of an already strong business franchise, or
concentrating on a single winning business theme, is what usually
produces exceptional economics.
Newspaper Business - It may not be coincidence that one newspaper leads in both
categories: an exceptionally “newsrich” product makes for broad audience appeal, which in turn leads to high penetration. Of course, quantity must be matched by quality. This not only means good reporting and good writing; it means freshness and relevance. To be indispensable, a paper must promptly tell its readers many things they want to know but won’t otherwise learn
until much later, if ever.
GAAP & Fraud - Then there are managers who actively use GAAP to deceive and defraud. They know that many investors and creditors accept GAAP results as gospel. So these charlatans interpret the rules “imaginatively” and record business transactions in ways that technically comply with GAAP but actually display an economic
illusion to the world.
As long as investors - including supposedly sophisticated institutions - place fancy valuations on reported “earnings” that march steadily upward, you can be sure that some managers and promoters will exploit GAAP to produce such numbers, no matter what the truth may be. Over the years, Charlie and I have observed many accounting-based frauds of staggering size. Few of the perpetrators have been punished; many have not even been censured. It has been far safer to steal large sums with a pen than small sums with a gun.
Newspaper Industry - A paper that is frequently late, because of production problems or distribution weaknesses, will lose customers, no matter how strong its editorial content.
But as happens in Wall Street all too often, what the wise do in the beginning, fools do in the end
EBDIT - Soon borrowers found even the new, lax standards intolerably binding. To induce lenders to finance even sillier transactions, they introduced an abomination, EBDIT - Earnings Before
Depreciation, Interest and Taxes - as the test of a company’s ability to pay interest. Using this sawed-off yardstick, the borrower ignored depreciation as an expense on the theory that it
did not require a current cash outlay.
Such an attitude is clearly delusional. At 95% of American businesses, capital expenditures that over time roughly approximate depreciation are a necessity and are every bit as real an expense as labor or utility costs. Even a high school dropout knows that to finance a car he must have income that covers not only interest and operating expenses, but also realistically-calculated depreciation. He would be laughed out of the bank if he started talking about EBDIT.
Financial Alchemy - But in the end, alchemy, whether it is metallurgical or
financial, fails. A base business can not be transformed into a golden business by tricks of accounting or capital structure. The man claiming to be a financial alchemist may become rich. But
gullible investors rather than business achievements will usually be the source of his wealth.
Low Cost Business - In contrast, “a business” earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack.
Forecasting - short-term market forecasts are poison and should
be kept locked up in a safe place, away from children and also
from grown-ups who behave in the market like children.
Volatility - We will continue to experience considerable volatility in our annual results. That’s assured by the general volatility of the stock market, by the concentration of our equity holdings in just a few companies, and by certain business decisions we have made, most especially our move to commit large resources to super-catastrophe insurance. We not only accept this volatility
but welcome it: A tolerance for short-term swings improves our long-term prospects.
Practice - Practice doesn’t make perfect; practice makes permanent.
The Market - In the short-run, the market is a voting
machine - reflecting a voter-registration test that requires only
money, not intelligence or emotional stability - but in the long-
run, the market is a weighing machine.|
Missed Opportunities - In 1938, more than 50 years after the introduction of Coke, and long after
the drink was firmly established as an American icon, Fortune did an excellent story on the company. In the second paragraph the writer reported: “Several times every year a weighty and serious investor looks long and with profound respect at Coca-Cola’s record, but comes regretfully to the conclusion that he is looking too late. The spectres of saturation and competition rise before
Yes, competition there was in 1938 and in 1993 as well. But it’s worth noting that in 1938 The Coca-Cola Co. sold 207 million cases of soft drinks (if its gallonage then is converted into the
192-ounce cases used for measurement today) and in 1993 it sold about 10.7 billion cases, a 50-fold increase in physical volume from a company that in 1938 was already dominant in its very major industry. Nor was the party over in 1938 for an investor: Though the $40 invested in 1919 in one share had (with dividends reinvested) turned into $3,277 by the end of 1938, a fresh $40 then invested in Coca-Cola stock would have grown to $25,000 by yearend 1993.
I can’t resist one more quote from that 1938 Fortune story: “It would be hard to name any company comparable in size to Coca-Cola and selling, as Coca-Cola does, an unchanged product that can point to a ten-year record anything like Coca-Cola’s.” In the 55 years that have since passed, Coke’s product line has broadened somewhat, but it’s remarkable how well that description still fits.
Diversification - Charlie and I decided long ago that in an investment lifetime it’s just too hard to make hundreds of smart decisions. That judgment became ever more compelling as Berkshire’s capital
mushroomed and the universe of investments that could significantly affect our results shrank dramatically. Therefore, we adopted a strategy that required our being smart - and not too smart at that
- only a very few times. Indeed, we’ll now settle for one good idea a year. (Charlie says it’s my turn.)
The strategy we’ve adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk,
using dictionary terms, as “the possibility of loss or injury.”
Academics, however, like to define investment “risk” differently, averring that it is the relative volatility of a stock or portfolio of stocks - that is, their volatility as compared to that of a large universe of stocks. Employing data bases and statistical skills, these academics compute with precision the “beta” of a stock - its relative volatility in the past - and then build arcane investment and capital-allocation theories around this calculation. In their hunger for a single statistic to measure
risk, however, they forget a fundamental principle: It is better to be approximately right than precisely wrong.
Volatility - In fact, the true investor welcomes volatility. Ben Graham explained why in Chapter 8 of The Intelligent Investor. There he introduced “Mr. Market,” an obliging fellow who shows up every day to either buy from you or sell to you, whichever you wish. The more manic-depressive this chap is, the greater the opportunities available to the investor. That’s true because a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses. It is impossible to see how the availability of such prices can be thought of as increasing the hazards for an investor who is totally free to either ignore the market or exploit its folly.
Sustainable Competitive Advantage - Moreover, both Coke and Gillette have actually increased their worldwide shares of market in recent years. The might of their brand names, the attributes of their products, and the strength of their distribution systems give them an enormous competitive advantage, setting up a protective moat around their economic castles. The average company, in contrast, does battle daily without any such means of protection. As Peter Lynch says, stocks of companies selling commodity-like products should come with a warning label: “Competition may prove hazardous to human wealth.”
Forecasts - We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. Thirty years ago, no one could have foreseen the
huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or
treasury bill yields fluctuating between 2.8% and 17.4%.
But, surprise - none of these blockbuster events made the slightest dent in Ben Graham’s investment principles. Nor did they render unsound the negotiated purchases of fine businesses
at sensible prices. Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when
apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.
Intrinsic Value Versus Book Value - We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move. Despite its fuzziness, however, intrinsic value is all-
important and is the only logical way to evaluate the relative
attractiveness of investments and businesses.
To see how historical input (book value) and future output (intrinsic value) can diverge, let’s look at another form of investment, a college education. Think of the education’s cost as its “book value.” If it is to be accurate, the cost should include the earnings that were foregone by the student because he
chose college rather than a job.
For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value. First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what he would have earned had he lacked his
education. That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day. The dollar result equals the intrinsic economic value of the education.
Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didn’t get his money’s worth. In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed. In
all cases, what is clear is that book value is meaningless as an indicator of intrinsic value.
Sellers - sellers sometimes care about placing their companies in a corporate home that will both endure and provide pleasant, productive working conditions for their managers.
The Importance Of The Float - Since 1967, when we entered the insurance business, our float has grown at an annual compounded rate of 20.7%. In more years than not, our cost of funds has been less than nothing. This access to “free” money has boosted Berkshire’s performance in a major way.
Any company’s level of profitability is determined by three items: (1) what its assets earn; (2) what its liabilities cost; and (3) its utilization of “leverage” - that is, the degree to which its assets are funded by liabilities rather than by equity. Over the years, we have done well on Point 1, having produced high returns on our assets. But we have also benefitted greatly - to a degree that is not generally well-understood - because our liabilities have cost us very little. An important reason for this low cost is that we have obtained float on very advantageous terms. The same cannot be said by many other property and casualty insurers, who may generate plenty of float, but at a cost that exceeds what the funds are worth to them. In those circumstances, leverage becomes a disadvantage.