Don’t invest in stocks, invest in the businesses behind them.
Currently the second richest person in the world after Bill Gates, Warren Buffett is also arguably the most successful investor of all time. Countless books have been written about him, but The Essays of Warren Buffett (edited by Lawrence Cunningham) is the only compendium of writings from the Sage of Omaha himself.
Cunningham’s book is a carefully chosen selection of Buffett’s famous annual letters to shareholders in Berkshire Hathaway, the fantastically profitable holding company that he has managed since the 1970s with partner Charlie Munger. Though it still owns large stakes in many publicly listed companies, it also buys outstanding private companies, which in 2006 had collective revenues of close to $100 billion.
Apart from a youthful apprenticeship with his mentor Benjamin Graham when he lived in New York, Buffett has always lived in Omaha, Nebraska, and his approach to investing is a long way from Wall Street in every sense. His letters to shareholders are eagerly anticipated because they contain many simple nuggets of wisdom, often delivered through amusing anecdotes or pithy sayings.
The following are some themes that emerge from his writings.
Look for underlying value
For Buffett, the key to winning in the stock market does not lie in predicting the market’s direction, but in knowing the value of businesses, irrespective of their current quoted price. He criticises investment advisers who waste time making forecasts about the economy, when it is much more important to find good businesses that will remain good for years to come.
He also dismisses efficient market theory (EMT), which holds that there is no point analysing and calculating the value of a business because the stock market, working with perfect efficiency, always reveals a company’s value through its share price.
Stock market prices for companies are driven by emotion, not truth, and the truth about a company lies in its operating results rather than its current stock price or its glossy forecasts. Berkshire often makes its best acquisitions when fear is at its highest or sentiment about the market at its lowest. For the investor in fundamentals, these are times to buy.
Markets are risky, good businesses are not
Buying stocks is generally seen to be about taking risks, but the Buffett way reduces risk to a minimum. Noting that many of his family members and close friends have invested the majority of their net worth in Berkshire Hathaway, he comments: ‘I’ve never believed in risking what my family and friends have and need in order to pursue what they don’t have and don’t need.’
There is no point in losing a night’s sleep over a stock play just to gain a bit more. Better to be so sure about an investment that the ups and downs of its stock price will not worry you. You know the company’s intrinsic worth and that the market will sooner or later recognise this. This is the essence of value investing.
Buffett famously does not invest in industries that he does not fully understand. He was widely criticised for not entering the technology stocks boom of the late 1990s, instead buying companies that produced boring things like paint, bricks and carpets. His golden rule is to invest only in your ‘circle of competence,’ areas you know something about, where you can understand how a company makes its money.
Lessons for the small investor
Many other lessons for the small investor can be drawn from Buffett’s essays, including:
- Invest only in companies whose earnings will surely be higher in the future than they are now.
- Look for companies that have a ‘durable competitive advantage.’ Even if their stock price goes up and down, this advantage will naturally see them outperform other stocks.
- When you do buy a stock, buy it for the long haul.
Buffett likes to invest in what he calls ‘the Inevitables,’ companies whose products will still be bought 10, 20, or 30 years from now, and whose brand is so famous it gives them the lion’s share of a market. Berkshire Hathaway has had large holdings in Coca-Cola and Gillette for many years because although elements like distribution, manufacturing processes, and product innovation will evolve, people will still be drinking Coke and needing to shave for their investment lifetimes, and they will turn to the trusted names.
His attitude is: If you find a small number of companies with a strong competitive advantage and at reasonable prices, why diversify? Paradoxically, putting more of your money into a smaller number of carefully chosen stocks means that you can relax. In any given year, Berkshire Hathaway may make only a handful of investments in the stock market, sometimes none at all. Often, Buffett notes, the smartest investment move is inactivity.
Buying for keeps
Along with its investments in the stocks of large corporations, Berkshire Hathaway has bought many smaller companies outright, such as Borsheim’s Fine Jewelry, See’s Candies and Nebraska Furniture Mart. These are often family enterprises lovingly built up over many years. The owners wish to realise some gains for all their hard work, yet do not want to sell to just anyone. When Berkshire Hathaway steps in everyone wins: The fund gets a fantastic business that will keep growing indefinitely, while the owners usually stay in place to keep running it, doing what they love. By selling to Buffett they receive guarantees that the business will not be merged with another, sold off, broken up, or moved from its home-town base.
Having owners with a strong emotional attachment to their company generally suggests the company will have honest accounting, respect for customers, pride in the product, and loyal and effective management in place; in short, integrity.
Once Buffett buys a company he intends to keep it, even if it goes through rough patches and does not contribute much to Berkshire Hathaway’s bottom line. In the meantime, the fund tries to get the problems fixed.
Berkshire Hathaway, he notes, has ‘the longest investment horizon to be found in the public-company universe.’
Investors in his fund are expected to hold on to their stock for many years, even passing it on to relatives after their death.
Though most of the essays in the book are a few years old, their basic lessons have not dated. Buffett established his investing style decades ago, and while it has undergone refinements, the philosophy remains: Work with people you like and trust, and as long the financial fundamentals are also good, prosperity will take care of itself. We have a tendency to think that anything related to business or money requires us to be hard nosed, but basic to Berkshire Hathaway’s fortunes has been developing a system for finding people who care.
What will happen when Buffett dies? His vast fortune is already being divested into the Bill and Melinda Gates Foundation but this does not mean that Berkshire Hathaway will be wound up. On the contrary, he and Munger have created a set of ‘business genes,’ a way of doing business that will outlive them no matter who is actually running the company. Ultimately, their greatest legacy may not simply be the enrichment of shareholders or the money that is given away, but demonstrating an investing philosophy that anyone can follow to their profit.
Though not really an easy read for beginner investors, with a little effort to understand the financial terms a purchase of The Essays of Warren Buffett will be amply rewarded.Related Links
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The Essays of Warren Buffett: Lessons for Investors and Managers
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Experienced readers of Warren Buffett's letters to the shareholders of Berkshire Hathaway Inc have gained an enormously valuable informal education. This book features letters that distill in plain words all the basic principles of sound business practices.