1. Buffett took his “retirement fund” of $174,000 and decided to start his own investment business. Two decades later, he was a billionaire.
The result is an eminently quotable collection of homespun investing wisdom:
· “Price is what you pay, value is what you get.” (2008)
· “For investors as a whole, returns decrease as motion increases.” (2005)
· “Be fearful when others are greedy and greedy only when others are fearful.” (2004)
· “You only find out who is swimming naked when the tide goes out.” (2001)
Below, we unpack 16 of the most important lessons from the last four decades of Berkshire Hathaway shareholder letters.
TABLE OF CONTENTS
· Executive compensation
· Executives should only eat what they kill
· Don’t give your executives stock options as compensation
· Stock ownership
· Buy stock as an owner, not a speculator
· Don’t ignore the value of intangible assets
· Conglomerates earned their terrible reputation
· Market volatility
· Ignore short-term movements in stock prices
· Be fearful when others are greedy, and greedy when others are fearful
· Save your money in peacetime so you can buy more during war
· Investment strategy
· Look for companies that reinvest their earnings into growth
· Don’t invest in businesses that are too complex to fully understand
· Invest in unsexy companies that build products people need
· Stock buybacks are often the best use of corporate cash
· Asset-heavy companies can be good investments
· Value investing
· Never invest because you think a company is a bargain
· Don’t invest only because you expect a company to grow
· Never use your own stock to make acquisitions
· Global economics
· America is not in decline — it’s becoming more and more efficient
· Current board of director incentives are broken and backward
· Management
· Embrace the virtue of sloth
· Time is the friend of the wonderful business, the enemy of the mediocre
· Complex financial instruments are dangerous liabilities
· Investment banker incentives are usually not your incentives
· Company culture
· Leaders should live the way they want their employees to live
· Hire people who have no need to work again in their lives
· Compensation committees have sent CEO pay out of control
· Debt
· Never use borrowed money to buy stocks
· Borrow money when it’s cheap
· Raising debt is like playing Russian Roulette
· Links to every Berkshire Hathaway shareholder letter
Executive compensation
1. Executives should only eat what they kill
In 1991, Berkshire Hathaway acquired the H. H. Brown Shoe Company, at the time the leading manufacturer of work shoes in North America. In his shareholder letter that year, Buffett talked about a few of the reasons why.
While Buffett recognized that shoes were a tough industry, he liked that H. H. Brown was profitable. He liked that the company’s CEO, Frank Rooney, would be staying on. And he definitely liked the company’s “most unusual” executive compensation plan, which he wrote, “warms my heart.”
At H. H. Brown, instead of managers getting stock options or guaranteed bonuses, every manager got paid $7,800 a year (the equivalent of about $14,500 today), plus “a designated percentage of the profits of the company after these are reduced by a charge for capital employed.”
Each manager, in other words, received a portion of the company’s profits minusthe amount that they spent, in terms of capital, to generate those profits. The result was that each manager at H. H. Brown had to “stand in the shoes of owners” and truly weigh whether the cost of a project was worth the potential results.
Buffett is a strong believer in this kind of “eat what you kill” philosophy of executive compensation.
In 2014, Buffett successfully lobbied the leadership of Coca-Cola — the largest position in Buffett’s portfolio at the time, with his ownership share coming in at 6.2% — to cut back on “excessive” executive compensation plans. Image source: ValueWalk
For Buffett, executive bonuses can work to motivate people to go above and beyond, but only when they’re closely tied to personal success in places within an organization where an executive has responsibility.
Too often, for Buffett, executive compensation plans impotently reward managers for nothing more than their firm’s earnings increasing or a stock price rising — outcomes for which the conditions were often created by a previous manager.
“At Berkshire… we use an incentive-compensation system that rewards key managers for meeting targets in their own bailiwicks,” Buffett wrote in his 1985 letter. “We believe good unit performance should be rewarded whether Berkshire stock rises, falls, or stays even. Similarly, we think average performance should earn no special rewards even if our stock should soar.”
At Berkshire Hathaway, Buffett enforces an individualized system of compensation that rewards managers for their personal actions — even if that means, counterintuitively, rewarding managers of individual units when the wider business doesn’t do well.
2. Don’t give your executives stock options as compensation
In 2000, the dotcom bubble burst. Across the world, companies shuttered their doors and investors lost thousands or even millions on their holdings.
At the same time, many executives at companies that had failed or suffered huge losses (and whose shareholders had suffered in turn) received record levels of compensation.
In spring 2001, Cisco’s shareholders had lost a total of 28.6% on their investment — yet CEO John Chambers took home $157M, mostly on his stock options (about $330,000 of that total consisted of direct, cash compensation).
At AOL, where shareholders had lost a total of 54.1%, CEO Steve Case came out with compensation totaling $164M. Again and again, at companies like Citigroup, Tyco, CMGI and others, CEOs made hundreds of millions while their shareholders faced heavy losses.
John Chambers, the former CEO of Cisco, at Davos in 2010. Image source: World Economic Forum
Buffett excoriated these leaders in his 2001 letter to shareholders.
“Charlie [Munger, Berkshire Hathaway vice chairman] and I are disgusted by the situation, so common in the last few years, in which shareholders have suffered billions in losses while the CEOs, promoters, and other higher-ups who fathered these disasters have walked away with extraordinary wealth.”
Buffett has several issues with the practice of CEOs granting themselves stock options as compensation.
First, there’s the problem of dilution. New options grants increase the number of shares of a company, diluting the existing pool of shareholders and reducing the value of shareholders’ current holdings. That means Buffett’s share of that company is worth less than it was before — contrary to Buffett’s beliefs that managers should work to increase the value of his share of the company, not decrease it.
Then there’s the corporate malfeasance possible when executives with a better understanding of their company’s value (or lack thereof) can leverage their own options into undeserved wealth.
Buffett writes, “Many of these [CEOs] were urging investors to buy shares while concurrently dumping their own, sometimes using methods that hid their actions. To their shame, these business leaders view shareholders as patsies, not partners.”
Lastly, options plans often allow firms to give their employees massive amounts of compensation without ever accounting for that compensation properly. Companies spending hundreds of millions giving unrestricted stock units to their employees can do deceptively, without reporting that cost to shareholders. In his 2018 letter, Buffett wrote,
“Managements sometimes assert that their company’s stock-based compensation shouldn’t be counted as an expense. What else could it be — a gift from shareholders?”
As far as his own company, Berkshire Hathaway, Buffett sticks to a ground rule he set down in 1956. As he wrote in 2001, his promise to his shareholders is that neither he nor his Vice Chairman Charlie Munger will take any “cash compensation, restricted stock or option grants that would make our results superior to yours.”
He adds: “Additionally, I will keep well over 99% of my net worth in Berkshire. My wife and I have never sold a share nor do we intend to.”
Stock ownership
3. Buy stock as an owner, not a speculator
When many investors buy stock, they become price-obsessed, constantly checking the ticker to see if they’re up or down money on any given day.
From Buffett’s perspective, buying a stock should follow the same kind of rigorous analysis as buying a business. “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes,” he wrote in his 1996 letter.
Rather than getting too caught up in the price or recent movement of a stock, Buffett says, buy from companies that make great products, that have strong competitive advantages, and that can provide you with consistent returns over the long term.
In short, buy stock in businesses that you would like to own yourself.
“Whenever Charlie and I buy common stocks for Berkshire’s insurance companies… we approach the transaction as if we were buying into a private business,” he wrote in his 1987 letter, “We look at the economic prospects of the business, the people in charge of running it, and the price we must pay. We do not have in mind any time or price for sale.”
Take his investment in (and later acquisition of) the auto insurer GEICO — an acquisition that has been called Buffett’s best ever.
GEICO represented everything Buffett was looking for as an investor. It had a great brand. It had a strong management team that he trusted. And when he first visited the company’s headquarters in 1951, he saw “the huge cost advantage the company enjoyed over the giants of the industry.” The combination of all these factors “set his heart afire.”
In 1951, Buffett made the decision to invest more half of his net worth in GEICO. He increased his holdings dramatically during the bear market of the mid-70s when GEICO was struggling. By 1995, he owned half of the company — and later that year, he arranged to buy the rest.
Warren Buffett admired Lou Simpson, the CIO of Geico from 1979 to 2010, so much that he once said that he would feel comfortable having Simpson replace him at Berkshire Hathaway. Image source: Wikipedia
“We agreed to pay $2.3 billion for the half of the company we didn’t own. That is a steep price. But it gives us full ownership of a growing enterprise whose business remains exceptional for precisely the same reasons that prevailed in 1951,” Buffett wrote in his 1995 letter.
Perhaps no other investment better represents Buffett’s ideal as this 50-year investment in GEICO.
Buffett concedes that those who invest in companies on the speculation that they may one day be worthwhile could reap returns — he just has no interest in that kind of investment. He prefers to invest in companies that are already successful (even if that success is undervalued by the market) and that have a strong chance of continuing success over the long term.
That conviction gives him the ability to buy even bigger portions of the companies in which he invests when the overall market goes into a downturn. With a speculator mentality, Buffett might have offloaded GEICO’s stock in the mid-70s. With a downturn in progress and healthy gains already realized, he would have come out ahead. With his owner mentality, however, Buffett used the downturn as an opportunity to amass an even greater share of the company.
In 2013, Buffett reported that GEICO had generated $73B for Berkshire Hathaway in one year — not a bad single-year return for a company that Buffett took over for $2.3B
4. Don’t ignore the value of intangible assets
Companies have both tangible assets (factories, capital, inventory) and intangible assets, which include things like reputation and brand. For Buffett, those intangible things are of the utmost importance for value-driven investors.
But he didn’t always believe that.
Earlier in his investing career, he admits, he was a servant of tangible assets only.
“I was taught to favor tangible assets and to shun businesses whose value depended largely upon economic Goodwill,” he wrote in 1983. “This bias caused me to make many important business mistakes of omission, although relatively few of commission.”
By 1983, however, Buffett’s attitude had changed — largely because of the success of one of his favorite businesses at the time, See’s Candy Stores.
In the early 70s, See’s was able to produce about $2M a year (after tax) on just $8M in net tangible assets (including all accounts receivable.) For a shop chain like See’s, that far exceeded expectations — and the reason for it, according to Buffett, was that the company enjoyed a subjective competitive advantage in the form of “a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.”
Berkshire Hathaway bought See’s, and by 1982, it was up to producing $13M after taxes on just $20M in net tangible assets.
When Berkshire Hathaway or anyone else buys a company, they pay a premium for the company’s subjective assets. That premium is the company’s “economic goodwill.”
When Berkshire first acquired See’s, they paid a small multiple to account for the fact that See’s was able to earn 25% of net tangible assets after tax — an impressive rate of return for a candy business. A few years later, however, See’s was earning 65% of its net tangible assets after tax.
Berkshire had paid a small premium upon acquisition to account for the company’s subjective advantage over other candy stores, but just a couple years later, that advantage had increased and made See’s an even more robust and profitable business. And this was an advantage that Buffett was beginning to see was inflation-proof.
During inflation, the conventional wisdom has been that businesses with lots of tangible capital resources were the best bets. With their factories and machinery, the thinking went, they could better weather the market impact of widespread lower purchasing power and higher costs.
However, Buffett found that “asset-heavy businesses generally earn lower rates of return… that often barely provide enough capital to fund the inflationary needs of existing businesses.”
Because of the success of See’s, Buffett realized that companies with relatively few tangible assets and “combined intangibles of lasting value” ultimately do best in an inflationary environment, because they have less costs to cover and higher rates of return on their existing capital.
“During inflation, Goodwill is the gift that keeps giving,” he concludes.
5. Conglomerates earned their terrible reputation
Conglomerates are corporations made up of multiple different businesses. According to Buffett, the term — which carries a negative connotation — has often been applied to Berkshire.
However, he argues that defining Berkshire as a conglomerate is only partially correct. And in his 2020 letter, Buffett goes on to explain that “conglomerates earned their terrible reputation” and why owning stocks in these businesses may not be the best investment strategy.
For one, conglomerates tend to buy companies in their entirety. But this approach leads to two problems. One, great businesses have “no interest in having anyone take them over,” says Buffett. And conglomerates then have to focus on mediocre companies that often lack competitive strengths.
The second problem is that gaining a controlling ownership in a company often requires paying an above-the-market share price, known as a control premium. To solve this problem, conglomerates often manufactured the overvaluation of their stocks. They then used these stocks to fund acquisitions in a manner that Buffett explains as, “I’ll pay you $10,000 for your dog by giving you two of my $5,000 cats.” But techniques and accounting maneuvers conglomerates used to overvalue stocks were often deceptive and sometimes even fraudulent.
Eventually, the illusion of investment success fades away. Conglomerates, once hailed by analysts, journalists, and bankers as business miracles, fall apart, and investors lose their money.
To avoid this outcome, Berkshire deploys a different strategy. This investment powerhouse has stakes in both controlled and non-controlled companies. Buffett says that “owning a non-controlling portion of a wonderful business is more profitable, more enjoyable and far less work than struggling with 100% of a marginal enterprise.”
Market volatility
6. Ignore short-term movements in stock prices
For the layman stock investor, the price is everything — buy low, sell high. There’s even a Wall Street proverb to this effect: “you can’t go broke taking a profit.”
Buffett disagrees completely with this approach, and he ranks this maxim as perhaps the “most foolish” of all of Wall Street’s sayings. And with Berkshire’s portfolio, he is adamant that the price of a stock is one of the least important factors to consider when deciding whether to buy or sell shares in a particular company.
The company’s operations and underlying value are the only things that matters, to Buffett. That’s because the price of a stock, on any given day, is mostly dictated by the whims of “Mr. Market” (Buffett’s metaphor for the mercurial movements of the broader stock market).
“Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his… Sad to say, the poor fellow has incurable emotional problems,” Buffett wrote in his 1987 letter.
For Buffett, investors succeed when they can ignore Mr. Market and his up-and-down emotional states. Instead, they look at whether the companies that they’re invested in are profitable, returning dividends to investors, maintaining high product quality, and so on.
Eventually, Buffett says, the market will catch up and reward those companies.
“In the short run, the market is a voting machine,” he writes, quoting Benjamin Graham, “But in the long run it is a weighing machine.”
7. Be fearful when others are greedy, and greedy when others are fearful
In the aftermath of the 2007-2008 financial crisis, few economic dogmas were hit harder than the efficient markets hypothesis, or the idea that the price of an asset reflects the market’s rational assessment of available information about it.
When it became clear that executives at some of the biggest banks on earth systematically underestimated the risks inherent to the assets they were trading in, it became difficult to defend the idea that prices were truly ever set rationally.
In the aftermath of the crisis, retail and institutional investors offloaded massive numbers of stocks in businesses weak and strong. Buffett, however, went on a personal buying spree, even penning an impassioned New York Times op-ed titled “Buy American” about the billions he had spent buying up marked-down stock.
Buffett is a moderate on the question of efficient markets and rational actors. Reflecting on the financial crisis, its consequences, and his profits from it, he wrote in 2017,
“Though markets are generally rational, they occasionally do crazy things. Seizing the opportunities then offered does not require great intelligence, a degree in economics or a familiarity with Wall Street jargon.”
Buffett believes that markets are generally efficient. That’s why he generally advises against bargain-hunting or “timing” your entry into a market: because trying to outsmart the wisdom of the crowd that sets prices is virtually impossible.
Buffett also believes that there are world-historical phases where all of that goes out the window — natural disasters, crashes, and other moments where emotions take over and rationalism flies out the window. He goes on,
“What investors then need instead is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals. A willingness to look unimaginative for a sustained period – or even to look foolish – is also essential.”
In uncertain or chaotic times, Buffett believes that savvy investors should continue looking at the fundamental value of companies, seeking companies that able to sustain their competitive advantage for a long time, and investing with an owner’s mentality. If investors can do that, they’ll naturally tend to go in the opposite direction of the herd — to “be fearful when others are greedy and greedy only when others are fearful,” as he wrote in 2004.
His reasoning is simple: when others are fearful, prices go down, but prices are only likely to remain low in the short term. In the long term, Buffett is bullish on any business that creates great products, has great management, and offers great competitive advantages.
By piling cash into distressed American companies like General Electric, Goldman Sachs, and Bank of America during the 2008 financial crisis, Buffett reportedly made $10B by 2013.
8. Save your money in peacetime so you can buy more during war
In 1973, Buffett made one of his most successful investments ever in the Washington Post.
At the time, the Post was widely regarded to have a value somewhere between $400M and $500M — though its stock ticker put it at only $100M. That was, for Buffett, a signal to buy. For just $10M, he was able to acquire more than 1.7M shares.
The underlying philosophy here is simple: hold onto your money when money is cheap, and spend aggressively when money is expensive.
In 1973, the country was still in the grips of a stock market crash that had begun in January. That slow-motion crash created a two-year-long bear market — the Dow Jones began 1973 at 1020 and was at 616 by the end of 1974. Shares of Coca-Cola, one of Buffett’s major stocks, plummeted from $149.75 to $44.50. Across the board, companies whose fundamentals had not changed were dramatically, in Buffett’s estimation, underpriced.
1973 marked the beginning of one of the biggest stock market downturns in history, particularly in the UK. Image source: Paul Townsend
The Washington Post’s stock suffered too, even after Buffett’s acquisition. After the end of 1974, the Post had officially been a loser for Berkshire Hathaway, falling from a value of $10.6M to $8M. But Buffett had a conviction the company’s fortunes would turn, and he knew he had picked up the company at a great price, despite the fact that it had fallen even more.
By the time Jeff Bezos acquired the paper in 2013, Buffett’s 1.7M share stake was worth about $1B — a more than 9,000% return.
“Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold,” Buffett wrote in 2016. “When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons.”
Investment strategy
9. Look for companies that reinvest their earnings into growth
Warren Buffett is well known for his love of companies that pay dividends, and Berkshire Hathaway has profited greatly from companies making payouts to their shareholders. In his 2019 shareholder letter, Buffett reported that Berkshire Hathaway’s top 10 stock investments had generated almost $3.8B in dividends over the previous year.
However, perhaps even more than paying dividends, Buffett values the corporate practice of reinvesting profits into growth.
Among those top 10 Berkshire Hathaway companies, the amount of earnings that are retained and reinvested is more than double the size of the earnings being paid out as dividends.
Over 2019, the value of Berkshire Hathaway’s “share” of earnings from those companies — including Apple, Coca-Cola, and American Express — amounted to more than $8.3B.
As Buffett notes in his 2019 letter, the value of retained earnings wasn’t always accepted among American investors. It wasn’t until 1924 that John Maynard Keynes wrote about the power of companies not giving to shareholders “the whole of their earned profits,” but instead retaining a part to put back into the business, thus creating “an element of compound interest operating in favour of a sound industrial investment.”
John Maynard Keynes. Image source: Foundation for Economic Education (FEE)
Today, this idea has become core to how Berkshire Hathaway operates. “At Berkshire, Charlie and I have long focused on using retained earnings advantageously,” Buffett writes.
His conviction about the power of retained earnings comes from his related conviction that the companies Berkshire invests in must share three properties:
- They earn “good returns on the net tangible capital required in their operation”
- They are run by “able and honest managers”
- They are available “at a sensible price”
When companies are priced well, run well, and return capital well, it is Buffett’s belief that they should be encouraged to reinvest their profits, not just throw cash to shareholders in the form of dividends.
Sometimes that means investing into new factories and growth, but it can also mean buying back stock, which Buffett also likes, as it “enlarges Berkshire’s share of the company’s future earnings.” Even if that doesn’t work out in the short term, Buffett thinks that over the long term, investing back into the company is generally the right strategy:
“Sometimes, alas, retentions produce nothing… It is certain that Berkshire’s rewards from these 10 companies, as well as those from our many other equity holdings, will manifest themselves in a highly irregular manner… Overall, the retained earnings of our investees are certain to be of major importance in the growth of Berkshire’s value.”
10. Don’t invest in businesses that are too complex to fully understand
When Berkshire Hathaway announced that it was taking a $1B stake in Apple in 2016, it surprised many of the company’s long-time observers — not because of Apple’s business model or stock price, but because Buffett had long claimed to have “insufficient understanding” of technology to invest in tech companies.
They were right to be suspicious: a few weeks later, Buffett confirmed that it was one of his recent manager hires who had pulled the trigger on the deal.
In his 1986 letter to shareholders, Buffett laid out the different aspects he and Munger were looking for in new companies, including “simple businesses.” He even went so far as to say that “if there’s lots of technology, we won’t understand it.”
More specifically, Buffett’s model states that it’s inadvisable to invest in a business where you cannot predict whether the company will have a long-term (20+ years or more) competitive advantage.
In his 2007 letter, Buffett expands on his thinking about which kinds of businesses he prefers to invest in. “A truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital,” he writes, “The dynamics of capitalism guarantee that competitors will repeatedly assault any business ‘castle’ that is earning high returns.”
When Buffett invests, he is not looking at the innovative potential of the company or, in a vacuum, its growth potential. He is looking for a competitive advantage.
“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow,” he writes “But rather determining the competitive advantage of any given company and, above all, the durability of that advantage.”
In 1999, when Wall Street analysts were extolling the virtues of virtually every dotcom stock on the market, Buffett was seeing a repeat of an earlier time: the invention of the automobile.
When the car was first invented, a naïve investor might have thought that virtually every automobile stock was guaranteed to succeed. At one point, there were 2,000 separate car brands just in the US. Of course, those didn’t all last.
“If you had foreseen, in the early days of cars, how this industry would develop, you would have said, ‘Here is the road to riches,’” Buffett writes. “So what did we progress to by the 1990s?” he asks. “After corporate carnage that never let up, we came down to three US car companies.”
He observes that the airplane industry suffered similarly. While the technological innovation was even more impressive than the car, the industry as a whole could be said to have failed most of its investors. By 1992, the collection of all airline companies produced in the US had produced a total of no profits whatsoever.
His conclusion about dotcom stocks at the time was simple: there will be a few winners, and an overwhelming majority of losers.
Correctly picking the winners requires understanding which companies are building a competitive advantage that will be defensible over the very long term. During the dotcom boom, that meant understanding how the infrastructure of the web would change over the next several decades — an impossible task for any observer at the time.
Buffett prefers to keep it simple, as he makes clear in his 1996 letter.
“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten, and twenty years from now.”
As for his lieutenants: Buffett hired Todd Combs and Ted Weschler in 2016, and allowed them to take positions without consulting with him beforehand. While Buffett himself may not feel comfortable taking a position in a company like Apple, he concedes that others might have stronger convictions about the future potential of an investment like that.
11. Invest in unsexy companies that build products people need
In his 1996 letter to shareholders, Buffett recounts Coca-Cola’s 1896 shareholder report, admiring how the company had set — and closely followed — its 100-year growth plan, while the core product of the company had not changed at all.
Buffett uses the example of Coca-Cola to explain one of the biggest tenets of his and Charlie Munger’s investing philosophy: invest in boring companies that are likely to be around for a long time, and avoid investing in anything innovative or revolutionary, no matter the returns you think it might achieve.Coca-Cola’s product has not changed in any meaningful way in over 100 years — just the way that Buffett, as both an investor and as a consumer, likes it.“I should emphasize that, as citizens, Charlie and I welcome change: fresh ideas, new products, innovative processes and the like cause our country’s standard of living to rise, and that’s clearly good,” Buffett states in his 1996 letter.
“As investors, however, our reaction to a fermenting industry is much like our attitude toward space exploration. We applaud the endeavor but prefer to skip the ride.”
Buffett goes on to discuss the Berkshire portfolio, which he says features all companies where he and Munger do not expect the underlying industries to change in a major way.
Wells Fargo, American Express, Walt Disney, Dairy Queen, Duracell — Buffett’s portfolio looks to some investors like a safe and generic mix, but it is rooted in a philosophy of long-term success.
“We are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now,” he writes, “A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek.”
This isn’t just Buffett’s philosophy, either. It’s been the philosophy behind some of his favorite companies, including Coca-Cola.
When Coca-Cola first started, it was turning something relatively cheap to produce — syrup — into a branded product. Over 100+ years, that brand has grown to encompass a broad range of human emotions and aspirations.
“‘Buy commodities, sell brands has long been a formula for business success. It has produced enormous and sustained profits for Coca-Cola since 1886,” he wrote in his 2011 letter.
Just as Coca-Cola built an empire buying syrup and selling a lifestyle, Buffett has made Berkshire Hathaway an empire by buying boring companies and selling their ever-returning dividends.
12. Stock buybacks are often the best use of corporate cash
Since Apple first began buying back its own stock in 2012, it has become one of most prolific stock repurchasers in history.
In H1’18, Apple set a record with $43.5B of stock buybacks. In May, it announced an additional $100B would be spent buying back Apple stock.
Some claimed the company lacked imagination and simply couldn’t figure out a more productive way to spend those billions.
One might expect a figure like Buffett — simple, no nonsense, and focused on intrinsic value — to balk at the energetic spending of capital on stock repurchases. Instead, he was delighted, especially by the idea that his 5% stake in the company might be able to grow to 6% or 7% simply because the company chose to buy back some of its stock.
Buffett is a bigger advocate of buybacks than many other investors and neutral observers of the stock market. At Berkshire Hathaway’s 2004 meeting, he claimed that “when stock can be bought below a business’s value, it is probably the best use of cash” for a company.
Apple headquarters in Cupertino. Apple’s $100B buyback plan, announced in spring 2018, made it the most prolific stock repurchaser in history. Image source: Wikipedia
The classic criticism of buybacks is that firms are spending money that should be spend on R&D and product improvement to buy back their own stock and boost the stock’s price — an artificial improvement to the ticker that doesn’t reflect an intrinsic increase in the value of the business.
While Buffett does disagree with executives who buy back their company’s shares simply because they have the cash to do it or to inflate earnings, he also believes in buying stocks when they’re underpriced.
When a company buys back its own stock because it sees that it is underpriced (according to the company’s estimation of its intrinsic value), it increases the ownership share of every shareholder in a way that Buffett likes:
“If Charlie and I think an investee’s stock is underpriced, we rejoice when management employs some of its earnings to increase Berkshire’s ownership percentage,” he wrote in his 2018 letter.
But when a company buys back its own stock while it is priced at or above the stock’s intrinsic value, the company is by definition overpaying. And a company that is in the habit of overpaying for anything — be it stock buybacks or new acquisitions — is not a good hold for a careful shareholder.
“Buying dollar bills for $1.10 is not good business for those who stick around,” Buffett wrote in 1999.
The most common culprits, for Buffett, are the kinds of executives who determine that they’re going to buy a certain amount of stock over a certain period of time.
For Buffett, there’s no difference between a CEO announcing this kind of stock repurchasing plan and a retail investor saying, “No matter the price, I will buy ‘X’ shares of Berkshire Hathaway over the next ‘Y’ months”— an investment strategy even he would deem incredibly foolish.
For Buffett, it is always “buy when it’s cheap” — never “buy just because.”
Buffett followed up on his buybacks strategy in 2020 as well. Berkshire spent $24.7B to buy back its own stock, the equivalent of 80,998 “A” shares.
That action “increased your ownership in all of Berkshire’s businesses by 5.2% without requiring you to so much as touch your wallet,” wrote Buffett to shareholders in his 2020 letter. And as Berkshire keeps repurchasing more of its shares, its shareholders will indirectly increase their ownership in Apple, BNSF, BHE, and other Berkshire-owned businesses.
13. Asset-heavy companies can be good investments
Buffett’s long-standing belief is that companies that run high-margin operations, require minimal assets, and can expand sales volume with little-to-no extra capital yield the best results.
But there are only so many companies that fit these three criteria.
No surprise, then, that Berkshire, as Buffett revealed in his 2020 letter, owns $154B worth of US-based property, equipment, and plants — more than any other American company.
He argues that asset-heavy companies “can be good investments,” with the Burlington Northern Santa Fe Railway (BNSF) and Berkshire Hathaway Energy (BHE) as prime examples. These two Berkshire-owned companies had combined earnings of $8.3B in 2020.
Buffett explains why investments in BNSF and BHE make sense. From 2010 to 2020, BNSF paid $41.8B in dividends to Berkshire, despite investing $41B in fixed assets. But the railroad company pays only what remains after it covers its needs and maintains a $2B cash balance. “This conservative policy allows BNSF to borrow at low rates, independent of any guarantee of its debt by Berkshire,” says Buffett.
Nevada Energy (a subsidiary of BHE) completed the 231-mile One Nevada Transmission Line in 2013, enabling the development of renewable energy projects in remote areas of the state. Image source: Las Vegas Review-Journal
BHE, however, has been paying no dividends on its common stock for the past 21 years. This electric-utility company is channeling all of its earnings into modernizing and expanding the outdated grid. These years-long investments are vital to ensure that electricity, produced by wind and solar sources in remote areas, can reach densely populated areas in the western US. Once completed, the modernized infrastructure will enable BHE to increase revenue and even start paying dividends.
Investing in asset-heavy companies is a long-term game. But Buffett welcomes it and says, “Though it will be many years before our western transmission project is completed, we are today searching for other projects of similar size to take on.”
Value investing
14. Never invest because you think a company is a bargain
Buffett’s distrust of bargains comes mostly from a series of poor acquisitions and investments he made early on in the life of Berkshire Hathaway.
One striking example that he discusses at length in his 1979 letter to shareholders is that of Waumbec Mills in Manchester, New Hampshire.
Buffett decided to purchase Waumbec Mills a few years prior because the business was priced so low — in fact, the price was below the working capital of the business itself, meaning Buffett acquired “very substantial amounts of machinery and real estate for less than nothing,” as he wrote in 1979.
It was, by all accounts, an incredible deal. But despite the appealing nature of the deal, the acquisition still turned out to be a mistake for Berkshire Hathaway. No matter how hard the company worked to turn the struggling business around, it could not get any traction.
The textile industry had simply gone into a downturn.
“In the end,” Buffett wrote in 1985, “Nothing worked and I should be faulted for not quitting sooner. A recent Business Week article stated that 250 textile mills have closed since 1980. Their owners were not privy to any information that was unknown to me; they simply processed it more objectively.”
Ultimately, Buffett’s distaste for cheap companies and their problems means that while some investors argue the merits of taking large positions in companies, Buffett and Berkshire Hathaway are comfortable taking relatively small positions in more expensive firms.
“At Berkshire, we much prefer owning a non-controlling but substantial portion of a wonderful company to owning 100% of a so-so business. It’s better to have a partial interest in the Hope Diamond than to own all of a rhinestone,” he wrote in 2014.
15. Don’t invest only because you expect a company to grow
Buffett is known for his advocacy of the value investing paradigm — buying shares of companies that are underpriced relative to their value according to some kind of analysis of company fundamentals, meaning its dividend yield, price-to-earnings multiple, price-to-book ratio, and so on.
Buffett’s personal formulation of the strategy is simply “finding an outstanding company at a sensible price” as opposed to finding mediocre companies for cheap prices.
But his embrace of “value investing” does not mean Buffett is skeptical of growth — it just means he avoids investing in companies solely because he thinks they have the potential to grow much larger than they are.
For a long time, however, Buffett notes in his 1992 letter, investors interested in “value” and investors interested in “growth” have been considered to be at odds.
Growth investors, the thinking goes, primarily look for companies that show they can grow at an above average rate. Companies that growth investors like might look expensive today, but are worth it if they are going to grow at or above the expected rate.
Value investors, on the other hand, purportedly ignore potential growth as a function in their fundamental analysis.
Buffett rejects this contrast, proudly proclaiming that “growth and value investing are joined at the hip.”
“Most analysts feel they must choose between two approaches customarily thought to be in opposition: ‘value’ and ‘growth,’” he wrote in his 1992 letter.
“We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago)… Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive,” he adds.
Value investing, for Buffett, means “seeking value at least sufficient to justify the amount paid.” Valuing a company higher because you expect it to exhibit healthy long-term growth is not the same as investing in a company solely because you believe it will grow and then justifying your valuation — a practice which Buffett is not fond of.
16. Never use your own stock to make acquisitions
One of Buffett’s self-proclaimed worst mistakes as an investor came with his all-stock acquisition of Dexter Shoe Company in 1993.
This was one of Berkshire Hathaway’s first major acquisitions in its transition to earning most of its revenue by acquiring other companies. Before this, Berkshire Hathaway had mostly made money from investing in stocks.
With Dexter Shoe, Buffett picked possibly the worst company to help in this transition.
Within a few years, the relatively high priced Dexter shoes were driven out of the market by a flood of cheap, imported versions. The price of the company went to virtually zero within just a few years. “What I had assessed as durable competitive advantage vanished within a few years,” he would write in his 2007 letter. He called it the worst deal of his entire career.
After Dexter Shoe fully shut down production in 2001, the town of Dexter went into a depression. According to Bloomberg, as of 2017, it has still not recovered. Image source: Wikipedia
What made this deal even worse for Buffett was the fact that he had conducted the deal not in cash — as he would virtually every other acquisition made through Berkshire Hathaway — but in Berkshire stock.
“By using Berkshire stock, I compounded this error hugely. That move made the cost to Berkshire shareholders not $400 million, but rather $3.5 billion. In essence, I gave away 1.6% of a wonderful business – one now valued at $220 billion – to buy a worthless business.”
Buying Dexter Shoe would have been a mistake either way, but using Berkshire stock to buy the company made the problem even worse. Instead of spending cash, Buffett spent a percentage of a business that proceeded to dramatically outperform the S&P 500 for the next decade. Each year that followed, his acquisition of Dexter Shoe became more and more expensive in retrospect, rubbing salt in the wound.
“My error caused Berkshire shareholders to give far more than they received (a practice that – despite the Biblical endorsement – is far from blessed when you are buying businesses).”
“Today, I would rather prep for a colonoscopy than issue Berkshire shares,” he later wrote.
Source : https://www.cbinsights.com/research/buffett-berkshire-hathaway-shareholder-letters/
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