Investing Like Warren Buffett | Part 4

Part 4 of our Investing Like Warren Buffett series discusses Berkshire Hathaway’s 1980 Chairman’s letter to shareholders. As always, I will focus on the important points highlighted in this material. Enjoy!!

Click here for 1980 Chairman’s Letter to Shareholders

Warren Buffett on non-controlled ownership earnings;

Non-Controlled Ownership Earnings

When one company owns part of another company, appropriate accounting procedures pertaining to that ownership interest must be selected from one of three major categories. The percentage of voting stock that is owned, in large part, determines which category of accounting principles should be utilized.

Generally accepted accounting principles require (subject to exceptions, naturally, as with our former bank subsidiary) full consolidation of sales, expenses, taxes, and earnings of business holdings more than 50% owned. Blue Chip Stamps, 60% owned by Berkshire Hathaway Inc., falls into this category. Therefore, all Blue Chip income and expense items are included in full in Berkshire’s Consolidated Statement of Earnings, with the 40% ownership interest of others in Blue Chip’s net earnings reflected in the Statement as a deduction for “minority interest”.

Full inclusion of underlying earnings from another class of holdings, companies owned 20% to 50% (usually called “investees”), also normally occurs. Earnings from such companies - for example, Wesco Financial, controlled by Berkshire but only 48% owned - are included via a one-line entry in the owner’s Statement of Earnings. Unlike the over-50% category, all items of revenue and expense are omitted; just the proportional share of net income is included. Thus, if Corporation A owns one-third of Corporation B, one-third of B’s earnings, whether or not distributed by B, will end up in A’s earnings. There are some modifications, both in this and the over-50% category, for intercorporate taxes and purchase price adjustments, the explanation of which we will save for a later day. (We know you can hardly wait.)

Finally come holdings representing less than 20% ownership of another corporation’s voting securities. In these cases, accounting rules dictate that the owning companies include in their earnings only dividends received from such holdings. Undistributed earnings are ignored. Thus, should we own 10% of Corporation X with earnings of $10 million in 1980, we would report in our earnings (ignoring relatively minor taxes on intercorporate dividends) either (a) $1 million if X declared the full $10 million in dividends; (b) $500,000 if X paid out 50%, or $5 million, in dividends; or (c) zero if X reinvested all earnings.

Warren Buffett on great investments;

“For capital to be truly indexed, return on equity must rise”. 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. Berkshire Hathaway isn’t one of them.

Warren Buffett on turnarounds;

“When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.”

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Investing like Warren Buffett | Part 3

Part 3 of our Investing like Warren Buffett series discusses his 1979 Chairman’s letter to shareholders of Berkshire Hathaway Inc. Let’s see what important investment advice he leaves with us this year.

Click here for 1979 Chairman’s Letter to Shareholders

 

“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.”

On Long Term Results

It is more important to pay attention to the long term results of stock ownership, rather than the short term performance. Unrealized gains or losses from stock ownership should be viewed different from the actual earnings from operations.

“In measuring long term economic performance - in contrast to yearly performance - we believe it is appropriate to recognize fully any realized capital gains or losses as well as extraordinary items, and also to utilize financial statements presenting equity securities at market value. Such capital gains or losses, either realized or unrealized, are fully as important to shareholders over a period of years as earnings realized in a more routine manner through operations; it is just that their impact is often extremely capricious in the short run, a characteristic that makes them inappropriate as an indicator of single year managerial performance.”

 

Be aware of those asset-intensive businesses with great economics, they may not always be great investments. Sometimes, a simple business is the better choice.

“In some businesses - a network TV station, for example - it is virtually impossible to avoid earning extraordinary returns on tangible capital employed in the business. And assets in such businesses sell at equally extraordinary prices, one thousand cents or more on the dollar, a valuation reflecting the splendid, almost unavoidable, economic results obtainable. Despite a fancy price tag, the “easy” business may be the better route to go.”

 

“We can speak from experience, having tried the other route. Your Chairman made the decision a few years ago to purchase Waumbec Mills in Manchester, New Hampshire, thereby expanding our textile commitment. By any statistical test, the purchase price was an extraordinary bargain; we bought well below the working capital of the business and, in effect, got very substantial amounts of machinery and real estate for less than nothing. But the purchase was a mistake. While we labored mightily, new problems arose as fast as old problems were tamed.”

On Turnarounds;

“Both our operating and investment experience cause us to conclude that “turnarounds” seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price.”

On attracting shareholders that have similar expectations through communication and policies;

“In large part, companies obtain the shareholder constituency that they seek and deserve. If they focus their thinking and communications on short-term results or short-term stock market consequences they will, in large part, attract shareholders who focus on the same factors.  And if they are cynical in their treatment of investors, eventually that cynicism is highly likely to be returned by the investment community.”

“Phil Fisher, a respected investor and author, once likened the policies of the corporation in attracting shareholders to those of a restaurant attracting potential customers. A restaurant could seek a given clientele - patrons of fast foods, elegant dining, Oriental food, etc. - and eventually obtain an appropriate group of devotees. If the job were expertly done, that clientele, pleased with the service, menu, and price level offered, would return consistently. But the restaurant could not change its character constantly and end up with a happy and stable clientele. If the business vacillated between French cuisine and take-out chicken, the result would be a revolving door of confused and dissatisfied customers.”

Lessons learned from this report:

1. Think long term when it comes to investing.
   
2. Buy businesses that are simple and easy to understand.
   
3. It is better to buy a good business at a fair price than a poor business at a bargain price.
   
4. Look for management that are honest and consistent in the communication and policies.

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Investing like Warren Buffett | Part 2

Part 2 of our Investing like Warren Buffett series discusses his 1978 Chairman’s letter to the shareholders of Berkshire Hathaway Inc. Since I am in the process of typing this and have not read it myself yet, I am excited to see what knowledge he had to impart on us at that stage of his life and investment career. This not only serves as great investment advice, but we are also able to learn how he analyzes businesses and what thought-processing went into picking the companies that became part of his investment portfolio.

I know we will also learn from his mistakes, which he is not shy about discussing in his letters as well. Let’s see what he has to share with us.

1978 Chairman’s letter to shareholders

Warren Buffett talks about investing in equity and his inability to predict stock market movements. What’s important is that he eludes to the fact that the equity holdings of his company will be worth a lot more than they paid, meaning that they were purchased with a significant margin of safety.

“We make no attempt to predict how security markets will behave; successfully forecasting short term stock price movements is something we think neither we nor anyone else can do. In the longer run, however, we feel that many of our major equity holdings are going to be worth considerably more money than we paid, and that investment gains will add significantly to the operating returns of the insurance group.”

Warren Buffett on textiles:

“Slow capital turnover, coupled with low profit margins on sales, inevitably produces inadequate returns on capital. Obvious approaches to improved profit margins involve differentiation of product, lowered manufacturing costs through more efficient equipment or better utilization of people, redirection toward fabrics enjoying stronger market trends, etc. Our management is diligently pursuing such objectives. The problem, of course, is that our competitors are just as diligently doing the same thing”

“The textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage.”

Warren Buffett again reiterates the criteria for selecting stocks for ownership. However, it is apparent that there are times where market prices do not offer great bargains.

”We get excited enough to commit a big percentage of insurance company net work to equities only when we find (1) businesses we can understand, (2) with favorable long-term prospects , (3) operated by honest and competent people, and (4) priced very attractively. We usually can identify a small number of potential investments meeting requirements (1), (2), (3), but (4) often prevents action.”

 

Buffett emphasizes that they will be net buyers of stocks in most years, therefore, as with any type of purchase, if you are the buyer, you would prefer to prices to be lower than higher. Therefore, this major principle is applied to stocks as well. The time to be buying is when prices are going down, not increasing.

“We are not concerned with whether the market quickly revalues upward securities that we believe are selling at bargain prices. In fact, we prefer just the opposite since, in most years, we expect to have funds available to be a net buyer of securities. And consistent attractive purchasing is likely to prove to be of more eventual benefit to us than any selling opportunities provided by a short-term run up in stock prices to levels at which we are unwilling to continue buying.”

 

Buffett on diversification. If you believe that a company has excellent future economics, he prefers to buy large quantities of that company, than allocating capital to many different companies.

“Our policy is to concentrate holdings. We try to avoid buying a little of this or that when we are only lukewarm about the business or its price. When we are convinced as to attractiveness, we believe in buying worthwhile amounts.”

 

Buffett talks about buying companies where management is already established.

“Of course, with a minor interest we do not have the right to direct or even influence management policies of SAFECO. But why should we wish to do this? The record would indicate that they do a better job of managing their operations than we could do ourselves. While there may be less excitement and prestige in sitting back and letting others do the work, we think that is all one loses by accepting a passive participation in excellent management. Because, quite clearly, if one controlled a company run as well as SAFECO, the proper policy also would be to sit back and let management do its job.”

 

Buffett on use of retained earnings, dividend payments and share repurchases.

“We are not at all unhappy when our wholly-owned businesses retain all of their earnings if they can utilize internally those funds at attractive rates. Why should we feel differently about retention of earnings by companies in which we hold small equity interests, but where the record indicates even better prospects for profitable employment of capital? (This proposition cuts the other way, of course, in industries with low capital requirements, or if management has a record of plowing capital into projects of low profitability; then earnings should be paid out or used to repurchase shares – often by far the most attractive option for capital utilization.)”

 

Another great report with some key points.
These are some points I learned from this report.

1. Do not attempt to forecast stock market movements. Focus on the underlying business.
2. Businesses with low capital turnover and low profit margins should be avoided as long-term investments.
3. Investments could fit all your criteria upon analysis, however, if the price is not right, it does not make a good investment. Be patient.
4. Management is very important when selecting businesses.

What have you gotten from this report.
Leave a comment.

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Investing like Warren Buffett | Part 1

Our new series will discuss the investing philosophy of Warren Buffett with direct excerpts from his Chairman’s letters to shareholders. As an investment student, this is a must read for all who intend to pursue such a feat. These letters are known to be one of the greatest sources of investment advice and is probably the most anticipated investment document each year.

We will start out series by studying and analyzing his letters all the way back to 1977 until present day. It may take us some time to do so, but I know at the end, we will have learned a great deal from this entire experience. Our investment I.Q. will surely raise several points, which is incentive enough to perform this task.

BERKSHIRE HATHAWAY (CLOCK TOWER)

 

1977 Letter to Stockholders of Berkshire Hathaway

Warren Buffett on Earnings Per Share:

“Most companies define “record” earnings as a new high in earnings per share. Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share. After all, even a totally dormant savings account will produce steadily rising interest rates earnings each year because of compounding."

What we, as investors, should be looking at:

“…we believe a more appropriate measure of managerial economic performance to be return on equity capital”.

Warren Buffett on long-term investing:

“…Most of our large stock positions are going to be held for many years and the scorecard on our investment decisions will be provided by business results over that period, and not by prices on any given day. Just as it would be foolish to focus unduly on short-term prospects when acquiring an entire company, we think it equally unsound to become mesmerized by prospective near term earnings or recent trends in earnings when purchasing small pieces of a company; i.e., marketable common stocks”.

Warren Buffett’s underlying investment philosophy has been the same since 1977. There is no significant difference in buying an entire company and buying shares of a company. Similar considerations must be made.

“We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) 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 of a good thing at a better price.”

“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. Consequently, bargains in business ownership, which simply are not available directly through corporate acquisition, can be obtained indirectly through stock ownership. When prices are appropriate, we are willing to take very large positions in selected companies, not with any intention of taking control and not foreseeing sell-out or merger, but with the expectation that excellent business results by corporations will translate over the long term into correspondingly excellent market value and dividend results for owners, minority as well as majority.”

The importance and role of management when selecting companies for stock or full ownership.

”Capital Cities possesses both extraordinary properties and extraordinary management. And these management skills extend equally to operations and employment of corporate capital.  To purchase, directly, properties such as Capital Cities owns would cost in the area of twice our cost of purchase via the stock market, and direct ownership would offer no important advantages to us. While control would give us the opportunity – and the responsibility – to manage operations and corporate resources, we would not be able to provide management in either of those respects equal to that now in place. In effect, we can obtain a better management result through non-control than control. This is an unorthodox view, but one we believe to be sound.”

I thought this to be an important part to include from this letter as it discusses Banking as investments. The point he was making was that a bank does not have to be a large bank to make it a good investment. The Illinois National Bank was an excellently run small bank that was extremely profitable.

“Earnings in 1977 amounted to $3.6 million, more than achieved by many banks two or three times its size.”

 

What I have learned from this report.

1. Warren Buffett’s investment philosophy has remained fundamentally the same today as it was decades ago.
2. Invest in stocks where you would feel comfortable owning the entire company.
3. Buy companies with great management; rather than thinking you can change the management yourself.
4. Buy companies that you understand with great management, favorable long-term economics, and most importantly at great prices.
5. Big does not always mean most profitable.

What knowledge have you gained from this report?
Leave a comment.

Berkshire's 2008 annual report: America's best days lie ahead

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