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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Warren Buffett U.N.C. 1996 lecture | Part 3: We want partners in Berkshire.

 

More questions from the U.N.C. Lecture Series.

3. Mr. Buffett, you invest in companies with managers you say you trust and admire. I would like to know who you trust and admire in business and politics today?

He mentions CEO of Cap Cities, Tom Murphy. He also admires the great two manager combination at The Coca Cola Company, (Roberto and Don) that took the market value from $5 billion to $60 billion in about 11 years. He also includes Bill Gates. Even though he understands nothing about Microsoft's business, he has great respect for Bill Gates as a businessman.

The most important advice he gave in his response to this question is:

"I think it is crazy to work with people that make your stomach churn, and if you are in a job like that, think about changing. Working with people you don't like in a business is kind of like marrying for money, which is probably a bad idea under normal circumstance, but it's crazy if you are rich. I work with people I like, I tap dance to work everyday and work with people who are terrific."

4. Have you considered splitting the stock?

Many have asked this question of Mr. Buffett previously and Berkshire has the highest price of any company that trades on the NYSE. His response was as always classic and consistent with his previous remarks.

"At Berkshire, I want to get people as shareholders, as partners of mine, who have the same expectations, same time horizons, the same methods of measurement that I have. It's crazy to go into business with people that have entirely different expectations than you have. The only way that I can affect that, since Berkshire is a public company, is through communication and policies. Therefore, I will try to have policies so that the right kind of people with similar expectations will be attracted to the company. I would like to have people as owners who would expect to own it the rest of their lives."

Essentially he goes on to say that by not splitting the stock, he eliminates people who are in the markets to trade actively, and these are not the people he would like as partners in Berkshire.

5. Discuss some of your investment mistakes.

Buffett says that he makes the most mistakes when he has a lot of cash available. Usually cash is king, but in more recent lectures, he states that cash is only king if it is being put to good use. Cash has no value if it just sits there doing nothing; it actually loses value.

Please refer to the video for the rest of his comments.