Buffett (1999): Regardless of the environment and the pressure one has, it always make sense to stick to one's circle of competence. "If your facts and reasoning are right, you don't have to worry about anybody else."

Warren Buffett would much prefer an environment of lower prices of equities than a higher one. We would now have a look on what the master has to offer in his 1999* letter to shareholders.

Taking leaf from history

If gold in the 1970s and the Japanese stock markets in the 1980s was one's ticket to becoming a millionaire, then one wouldn't have gone too wrong investing in tech stocks or to be more specific, the NASDAQ in the 1990s. Not surprisingly then, investors who did not have a single tech stock in their portfolios would have had a high probability of lagging the overall markets. The master's aversion to tech stocks is now legendary and he too was caught at the wrong end of the tech stick. While he did reasonably well in the earlier part of the 90s decade, in the year 1999, the numbers finally caught up with him and he recorded, what he himself termed the worst absolute performance of his tenure. It was not as if the master made some big mistakes but some of the businesses that his investment vehicle operated had a disappointing year and the problem got magnified because of the great success stories elsewhere, notably the tech sector.

It is seldom that investors of caliber of Buffett go wrong and when they do, it does provide a lot of fodder for the media. Quite expectedly then, magazines and newspapers pounced on the story and titles like 'Has the Buffett era ended?’ or ‘What's wrong Mr. Buffett?’ were not very uncommon to find. The master however refused to buckle under pressure and maybe followed the dictum of his mentor Benjamin Graham who had once famously said - "You're neither right nor wrong because other people agree with you. You're right because your facts are right and your reasoning is right-and that's the only thing that makes you right. And if your facts and reasoning are right, you don't have to worry about anybody else."

The master had reasoned that tech stocks did not come inside his circle of competence and he had hard time valuing them as he was not aware what such businesses would look like 5 to 10 years down the line. Investors can indeed draw one big lesson from this event. Regardless of the environment and the pressure one has, it always make sense to stick to one's circle of competence. Only those people who are able to do this on a consistent basis can increase their chances of earning attractive returns on their investments on a consistent basis.

And was the master proved right? Indeed! Other investors lapped up tech stocks on the premise that although they did not understand the business fully they would surely find another buyer to whom they will sell. Although this trend did last for a few years, when the bubble burst, it left a lot of financial destruction in its wake. The master surely had the last laugh.

While there have been a lot of theories floating around on the master's aversion to tech stocks, in the letter for the year 1999, he has laid out a few reasons on why he would not consider investing in tech stocks. Let us read the master's own words what he has to say on the issue.

Buffett in his own words


"Our problem - which we can't solve by studying up - is that we have no insights into which participants in the tech field possess a truly durable competitive advantage. Our lack of tech insights, we should add, does not distress us. After all, there are a great many business areas in which Charlie (Buffett’s business partner) and I have no special capital-allocation expertise. For instance, we bring nothing to the table when it comes to evaluating patents, manufacturing processes or geological prospects. So we simply don't get into judgments in those fields.”

He further says, “If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter. If others claim predictive skill in those industries - and seem to have their claims validated by the behavior of the stock market - we neither envy nor emulate them. Instead, we just stick with what we understand. If we stray, we will have done so inadvertently, not because we got restless and substituted hope for rationality. Fortunately, it's almost certain there will be opportunities from time to time for Berkshire to do well within the circle we've staked out."

Buffett (1997): Would much prefer an environment of lower prices of equities than a higher one.

"Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices."




Warren Buffett talked about the discipline in investing by using a baseball analogy in his 1997 letter to shareholders. Let us go further down the same letter to see what other investment wisdom he has to offer.

Have you ever wondered, "Why is it that whenever departmental or garment stores announce their yearly sales, people flock to these places and purchase goods by the truckloads but the very same people will not put a dime when similar situation plays itself out in the stock market." Indeed, whenever one is confident of the future direction of the economy, like we currently are of India, corrections of big magnitudes in the stock market can be viewed as an excellent buying opportunity. This is because just as in the case of departmental or grocery stores, a large number of stocks are available at 'sale' during these corrections and hence, one should not let go of such opportunities without making huge purchases. This is exactly what the master has to say through some of the comments in his 1997 letter to shareholders that we have reproduced below.

"A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves."

"But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices."

Simple isn't it! If someone is expected to be a buyer of certain goods over the course of the next few years, he or she will definitely be elated if prices of the goods fall. So why have a different attitude while making stock purchases. Having such frames of reference in mind helps one avoid the herd mentality and make rational decisions. Hence, the next time the stock market undergoes a big correction; think of it as one of those sales where good quality stocks are available at attractive prices and then it will certainly be difficult for you to not to make an investment decision.

Buffett (1997): "All men's miseries derive from not being able to sit quiet in a room alone."

Warren Buffett's 1996 letter to shareholders provided advice to investors who want to build their own portfolios. Let us now proceed to the letter from the year 1997 and see what investing gems lie hidden in it.

A mathematician’s wisdom true to investing

"All men's miseries derive from not being able to sit quiet in a room alone", said the noted mathematician Blaise Pascal. These words ring true in the world of investing if not anywhere else. As much as the fundamentals of the company are important while making investment decisions, key consideration has to be given to the price as well. For even the best of businesses bought at expensive valuations are not likely to lead to attractive returns.

This is where discipline plays a key role. In an environment where prices are rising and each man and his aunt is making money, it is very difficult to remain sane especially with regards to valuations. As the master himself admits that although it is not possible to predict when prices will come down and to what extent, one can do a world of good to one's investment returns if good businesses are bought at decent prices. In fact, the master is believed to have waited as much as few decades for some of his investments to come down at valuations that he was comfortable with and the ones that he believed incorporated a sufficient margin of safety.

What’s your margin of safety?

So, what is the master preaching?

In his 1997 letter to shareholders, Warren Buffett has compared this predicament to a game of baseball and this is what he has to say on the issue:

Though we are delighted with what we own, we are not pleased with our prospects for committing incoming funds. Prices are high for both businesses and stocks. That does not mean that the prices of either will fall – we have absolutely no view on that matter – but it does mean that we get relatively little in prospective earnings when we commit fresh money.”

He further states, “Under these circumstances, we try to exert a Ted Williams kind of discipline. In his book ‘The Science of Hitting’, Ted explains that he carved the strike zone into 77 cells, each the size of a baseball. Swinging only at balls in his ‘best’ cell, he knew, would allow him to bat .400; reaching for balls in his ‘worst’ spot, the low outside corner of the strike zone, would reduce him to .230. In other words, waiting for the fat pitch would mean a trip to the Hall of Fame; swinging indiscriminately would mean a ticket to the minors.”

Discipline in investing is the key

Finally, he asserts, “If they are in the strike zone at all, the business ‘pitches’ we now see are just catching the lower outside corner. If we swing, we will be locked into low returns. But if we let all of today's balls go by, there can be no assurance that the next ones we see will be more to our liking. Perhaps the attractive prices of the past were the aberrations, not the full prices of today. Unlike Ted, we can't be called out if we resist three pitches that are barely in the strike zone; nevertheless, just standing there, day after day, with my bat on my shoulder is not my idea of fun.”

Buffett (1994): "In setting compensation, we like to hold out the promise of large carrots, but make sure their delivery is tied directly to results in the area that a manager controls.

Warren Buffett wrote on how corporate managers destroy shareholder value by resorting to unwanted acquisitions through his 1994 letter to shareholders. Let us proceed further in the same letter and see what other investment wisdom the master has to offer.

The current mortgage crisis in the US has put the global economy on the brink of a recession and has made big dents in the balance sheets of some of world's top financial institutions. Thus, with damages of such a magnitude, it is only natural to assume that the heads of these institutions during whose tenure the crisis took place should face financial penalties of some kind. However, if the pay packets of some of these executives are any indication, people harboring such notions are doing nothing but wallowing in outright fantasy. As per reports, CEOs of some of these institutions who have posted billions of dollars of losses due to the sub prime crisis will continue to rake in millions of dollars. All that shareholders get by way of solace is their ouster by the board or voluntary resignation. So much for alignment of shareholders' interest with that of the CEO or the management!

This is not a standalone case and there have been many such instances in the past where despite bringing companies down to their knees, CEOs and top management have gone on to earn fat salaries. Certainly, boots that all of us would love to get into! After all who would not want to lead a company where while salaries are tied to profits on the upside, there is no financial punishment to speak of when losses happen by the billions.

Yet, practices like these are commonplace in the corporate world and year after year, shareholders of troubled companies have to bear the egregious costs of the animal like aggressive instincts of its management. Thus, in order to avoid traps like these, it becomes important that when we as investors invest, we should have a close look at the compensations that the management gets in times both good as well as bad and see whether the company has a proper compensation system in place. A lot can be learnt if we have a look at how the master plans compensation for executives in the companies Berkshire own and his views on the issue. This is what he has to say on fair compensation practices.

"In setting compensation, we like to hold out the promise of large carrots, but make sure their delivery is tied directly to results in the area that a manager controls. When capital invested in an operation is significant, we also both charge managers a high rate for incremental capital they employ and credit them at an equally high rate for capital they release.

It has become fashionable at public companies to describe almost every compensation plan as aligning the interests of management with those of shareholders. In our book, alignment means being a partner in both directions, not just on the upside. Many "alignment" plans flunk this basic test, being artful forms of "heads I win, tails you lose."

In all instances, we pursue rationality. Arrangements that pay off in capricious ways, unrelated to a manager's personal accomplishments, may well be welcomed by certain managers. Who, after all, refuses a free lottery ticket? But such arrangements are wasteful to the company and cause the manager to lose focus on what should be his real areas of concern. Additionally, irrational behavior at the parent may well encourage imitative behavior at subsidiaries."

http://www.equitymaster.com/detail.asp?date=2/21/2008&story=3

Buffett (1994): Don't get bogged down by near term outlook and strong earnings growth; look for the best risk adjusted returns on a long-term basis

Warren Buffett highlighted in his 1994 letter to shareholders, the futility in trying to make economic prediction while investing. Let us go further down the same letter and see what other investment wisdom the master has to offer.

One of the biggest qualities that separate the master from the rest of the investors is his knack of identifying on a consistent basis, investments that have the ability to provide the best risk adjusted returns on a long-term basis. In other words, the master does a very good job of arriving at an intrinsic value of a company based on which he takes his investment decisions. Indeed, if the key to successful long-term investing is not consistently identifying opportunities with the best risk adjusted returns than what it is.

However, not all investors and even the managers of companies are able to fully grasp this concept and get bogged down by near term outlook and strong earnings growth. This is nowhere more true than in the field of M&A where acquisitions are justified to the acquiring company's shareholders by stating that these are anti-dilutive to earnings and hence, are good for the company's long-term interest. The master feels that this is not the correct way of looking at things and this is what he has to say on the issue.

"In corporate transactions, it's equally silly for the would-be purchaser to focus on current earnings when the prospective acquiree has either different prospects, different amounts of non-operating assets, or a different capital structure. At Berkshire, we have rejected many merger and purchase opportunities that would have boosted current and near-term earnings but that would have reduced per-share intrinsic value. Our approach, rather, has been to follow Wayne Gretzky's advice: "Go to where the puck is going to be, not to where it is." As a result, our shareholders are now many billions of dollars richer than they would have been if we had used the standard catechism."

He goes on to say, "The sad fact is that most major acquisitions display an egregious imbalance: They are a bonanza for the shareholders of the acquiree; they increase the income and status of the acquirer's management; and they are a honey pot for the investment bankers and other professionals on both sides. But, alas, they usually reduce the wealth of the acquirer's shareholders, often to a substantial extent. That happens because the acquirer typically gives up more intrinsic value than it receives."

Indeed, rather than giving in to their adventurous instincts, managers could do a world of good to their shareholders if they allocate their capital wisely and look for the best risk adjusted return from the excess cash they generate from their operations. If such opportunities turn out to be sparse, then they are better off returning the excess cash to shareholders by way of dividends or buybacks. However, unfortunately not all managers adhere to this routine and indulge in squandering shareholder wealth by making costly acquisitions where they end up giving more intrinsic value than they receive.

http://www.equitymaster.com/detail.asp?date=2/7/2008&story=2

Buffett (1994): Investing can be done successfully even without making an attempt to figure out the unknowables.

Staying within one's circle of competence and investing in simple businesses were some of the key points that were discussed in Warren Buffett's 1993 letter to shareholders. Now let us fast forward to the year 1994 and see what investment wisdom the master has to offer in this letter.

Are you one of those guys who are quite keen on learning the nitty-gritty of the stock market but the sheer size of literature that is on offer on the topic makes you nervous? Further, with the kind of resources that the institutions, the ones that you would compete against, have at their disposal, it is quite normal for you to give up the thought without even having tried. Indeed, things like coming out with quaint economic theories, crunching a mountain of numbers and working on sophisticated spread sheets should be best left to professionals. While it is definitely good to be wary of the competition, in investing, one can still comfortably beat the competition without the aid of the sophisticated tools mentioned above. All it needs is loads of discipline and patience.

Thus, for those of you, who in an attempt to invest successfully, are trying to predict the next move of the Fed chief or trying to outguess fellow investors on which party will come to power in the next national elections, you are well advised to stop in your tracks because investing can be done successfully even without making an attempt to figure out these unknowables. Some words of wisdom along similar lines come straight from the master's 1994 letter to shareholders and this is what he has to say on the topic.

"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.

A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results."

Infact, the master is not alone in his thinking on the subject but has an equally successful supporter who goes by the name of 'Peter Lynch', one of the most revered fund managers ever. He had once famously quipped, "If you spend 13 minutes per year trying to predict the economy, you have wasted 10 minutes".

Indeed, if these guys in their extremely long investment career could continue to ignore political and economic factors and focus just on the strength of the underlying business on hand and still come out triumphant, we do not see any reason as to why the same methodology cannot be copied here with equally good results.

http://www.equitymaster.com/detail.asp?date=2/1/2008&story=8

Buffett (1993): Staying within one's circle of competence and investing in simple businesses

A key mistake of investors was they never tried to fathom the relationship between the stock and the underlying business.
One should stick with the ones that can be easily understood and not subject to frequent changes.
"Why search for a needle buried in a haystack when one is sitting in plain sight?"

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In the darkest days in the stock market history, there is no better time than this to imbibe the lessons being imparted by the master in value investing, a discipline or a form of investing that we think is one of the safest around.

One of the key mistakes the investors who suffered the most in the recent decline made was they never tried to fathom the relationship between the stock and the underlying business. Instead, they bought what was popular and hoping that there will still be a greater fool out there who would in turn buy from them. We believe that no matter how good the underlying business is, there is always an intrinsic value attached to it and one should not pay even a dime more for the same. Alas, this was not to be the case in the stock markets in recent times for many 'investors', where no effort was being made to evaluate the business model and the sustainability or longevity of the business.

In his 1993 letter to shareholders, the master has a very important point to say on why it is important to know the company or the industry that one invests in. This is what he has to offer on the topic.

"In many industries, of course, Charlie and I can't determine whether we are dealing with a "pet rock" or a "Barbie." We couldn't solve this problem, moreover, even if we were to spend years intensely studying those industries. Sometimes our own intellectual shortcomings would stand in the way of understanding, and in other cases the nature of the industry would be the roadblock. For example, a business that must deal with fast-moving technology is not going to lend itself to reliable evaluations of its long-term economics. Did we foresee thirty years ago what would transpire in the television-manufacturing or computer industries? Of course not. (Nor did most of the investors and corporate managers who enthusiastically entered those industries.) Why, then, should Charlie and I now think we can predict the future of other rapidly evolving businesses? We'll stick instead with the easy cases. Why search for a needle buried in a haystack when one is sitting in plain sight?"

As is evident from the above paragraph, an investor does himself no good in the long-run if he keeps on investing without understanding the economics of the underlying business. Infact, even when one is close to cracking the industry economics, some industries are best left alone because they are so dynamic that rapid technological changes might put their very existence at risk. Instead, one should stick with the ones that can be easily understood and not subject to frequent changes.

http://www.equitymaster.com/detail.asp?date=1/24/2008&story=3

Buffett (1993): His views on real risk and how 'beta" fails to spot competitive strengths inherent in certain companies

Concentration over excessive diversification and the futility of using a stock's beta were the two key concepts that were discussed in Warren Buffett's 1993 letters to shareholders. However, the master does not stop here and, in the follow up paragraphs, puts forth his views on what is the real risk that an investor should evaluate and how the 'beta' as defined by the academicians fails to spot competitive strengths inherent in certain companies.

First up, the master explains what is the real risk that an investor should assess and goes on to suggest that the first thing that needs to be looked at is whether the aggregate after tax returns from an investment over the holding period keeps the purchasing power of the investor intact and gives him a modest rate of interest on that initial stake. He is of the opinion that though this risk cannot be measured with engineering precision, in a few cases it can be judged with a degree of accuracy. The master then lists out a few primary factors for evaluation. These would be:

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  The certainty with which the long-term economic characteristics of the business can be evaluated;

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  The certainty with which management can be evaluated, both as to its ability to realise the full potential of the business and to wisely employ its cash flows;

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• 
  
  The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself;

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• 
  
  The purchase price of the business; and

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  The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor's purchasing-power return is reduced from his gross return.

Indeed, the above qualitative parameters are not likely to go down well with analysts who are married to their spreadsheets and sophisticated models. But this in no way reduces their importance. These parameters, the master says, may go a long way in helping an investor see the risks inherent in certain investments without reference to complex equations or price histories.

Buffett further goes on to add that for a person who is brought up on the concept of beta will have difficulties in separating companies with strong competitive advantages from the ones with mundane businesses and this he believes is one of the most ridiculous things to do in stock investing. This is what he has to say in his own inimitable style.

"The competitive strengths of a Coke or Gillette are obvious to even the casual observer of business. Yet the beta of their stocks is similar to that of a great many run-of-the-mill companies who possess little or no competitive advantage. 

• Should we conclude from this similarity that the competitive strength of Coke and Gillette gains them nothing when business risk is being measured? 
• Or should we conclude that the risk in owning a piece of a company - its stock - is somehow divorced from the long-term risk inherent in its business operations? 

We believe neither conclusion makes sense and that equating beta with investment risk also makes no sense."

He further states, "The theoretician bred on beta has no mechanism for differentiating the risk inherent in, say, a single-product toy company-selling pet rocks or hula hoops from that of another toy company whose sole product is Monopoly or Barbie. But it is quite possible for ordinary investors to make such distinctions if they have a reasonable understanding of consumer behavior and the factors that create long-term competitive strength or weakness. Obviously, every investor will make mistakes. But by confining himself to a relatively few, easy-to-understand cases, a reasonably intelligent, informed and diligent person can judge investment risks with a useful degree of accuracy."

http://www.equitymaster.com/detail.asp?date=1/17/2008&story=2

Buffett (1993): He believes in making infrequent large bets. "We'll now settle for one good idea a year."

Warren Buffett's 1992 letter to shareholders shared his views on healthcare accounting and ESOPs. Let us now see what insight the master has to offer in his 1993 letter to shareholders.

Ardent followers of the master might not be immune to the fact that whenever an extremely attractive opportunity has presented itself, Buffett has not hesitated to put huge sums in it. In sharp contrast to the current lot of fund manager who use fancy statistical tools to justify diversification, the master has been a believer in making infrequent bets but at the same time making large bets. In other words, he believes that a concentrated portfolio is much better than a diversified portfolio. This is what he has to say on the issue.

"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."

The master does not stop here. Like his previous letters, he once again takes potshots at academicians who define risk as the relative volatility of a stock price with respect to the market or what is now widely known as 'beta'. He very rightly contests that a stock which has been battered by the markets should as per the conventional wisdom bought in ever larger quantities because lower the price, higher the returns in the future. However, followers of beta are very likely to shun the stock for its perceived higher volatility. This is what he has to say on the issue.

"In assessing risk, a beta purist will disdain examining what a company produces, what its competitors are doing, or how much borrowed money the business employs. He may even prefer not to know the company's name. What he treasures is the price history of its stock. In contrast, we'll happily forgo knowing the price history and instead will seek whatever information will further our understanding of the company's business. After we buy a stock, consequently, we would not be disturbed if markets closed for a year or two. We don't need a daily quote on our 100% position in See's or H. H. Brown to validate our well-being. Why, then, should we need a quote on our 7% interest in Coke?"

http://www.equitymaster.com/detail.asp?date=1/10/2008&story=5

Buffett (1992): "How many legs does a dog have if you call his tail a leg?"

The master has taken potshots at every accounting convention that understates liabilities and overstates profits and asks investors to guard against such measures. Things like ESOPs and post retirement health benefits should be appropriately accounted for and considered as costs.



In his 1992 letter to shareholders, Warren Buffett's discoursed on valuations and intrinsic value.  In the same letter, let us see what he has to speak on employee compensation accounting and stock options.

In the year 1992, two new accounting rules came into being out of which one mandated companies to create a liability on the balance sheet to account for present value of employees' post retirement health benefits. The master used the occasion to turn the tables on managers and chieftains who under the pretext of the old method avoided huge dents on their P&Ls and balance sheets. The earlier method required accounting for such benefits only when they are cashed but did not take into account the future liabilities that would arise thus overstating the net worth as well as profits by way of inadequate provisioning. This is what the master had to say on the issue.

"Managers thinking about accounting issues should never forget one of Abraham Lincoln's favorite riddles: "How many legs does a dog have if you call his tail a leg?" The answer: "Four, because calling a tail a leg does not make it a leg." It behooves managers to remember that Abe's right even if an auditor is willing to certify that the tail is a leg."

By quoting the above statements, the master has taken potshots at every accounting convention that understates liabilities and overstates profits and asks investors to guard against such measures. Next he criticizes accounting standard for ESOPs prevailing in the US at that time and this is what he has to say on the topic.

"Typically, executives have argued that options are hard to value and that therefore their costs should be ignored. At other times, managers have said that assigning a cost to options would injure small start-up businesses. Sometimes they have even solemnly declared that "out-of-the-money" options (those with an exercise price equal to or above the current market price) have no value when they are issued.

Oddly, the Council of Institutional Investors has chimed in with a variation on that theme, opining that options should not be viewed as a cost because they "aren't dollars out of a company's coffers." I see this line of reasoning as offering exciting possibilities to American corporations for instantly improving their reported profits. For example, they could eliminate the cost of insurance by paying for it with options. So if you're a CEO and subscribe to this "no cash-no cost" theory of accounting, I'll make you an offer you can't refuse: Give us a call at Berkshire and we will happily sell you insurance in exchange for a bundle of long-term options on your company's stock."

The master has hit the nail on the head when he has further gone on to mention that something of value that is delivered to another party always has costs associated with it and these costs come out of the shareholders' pockets. Thus, things like ESOPs and post retirement health benefits should be appropriately accounted for and should not be hidden under the garb of fuzzy accounting standards and ingenious rationales.

Before we round off the 1992 letter, let us see how the master in a way that he only can so strongly puts up the case for ESOPs to be considered as costs.

• "If options aren't a form of compensation, what are they? 

• If compensation isn't an expense, what is it? 

• And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?"

http://www.equitymaster.com/detail.asp?date=12/27/2007&story=4

****Buffett (1992): Do not categorise stocks into growth and value types, the two approaches are joined at the hip

Warren Buffett's 1992 letter to his shareholders touched upon his views on short-term forecasting in equity markets and how it could prove worthless. In the following few paragraphs, let us go further down through the letter and see what other investment wisdom he has on offer.

Most of the financing community puts stock investments into one of the two major categories viz. growth and value. It is of the opinion that while the former category comprises stocks that have potential of growing at above average rates, the latter category stocks are likely to grow at below average rates. However, the master belongs to an altogether different camp and we would like to mention that such a method of classification is clearly not the right way to think about equity investments. Let us see what Buffett has to say on the issue and he has been indeed very generous in trying to put his thoughts down to words.

"But how, you will ask, does one decide what's 'attractive'? In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition: 'value' and 'growth'. Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.

We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: 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.

In addition, we think the very term 'value investing' is redundant. What is 'investing' if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation (which is neither illegal, immoral nor - in our view - financially fattening).

Whether appropriate or not, the term 'value investing' is widely used. Typically, it connotes the purchase of stocks having attributes such as 

• a low ratio of price to book value, 
• a low price-earnings ratio, or 
• a high dividend yield. 

Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments.

Correspondingly, opposite characteristics - 

• a high ratio of price to book value, 
• a high price-earnings ratio, and 
• a low dividend yield 

- are in no way inconsistent with a 'value' purchase.

Similarly, business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.

Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor."

If understood in their entirety, the above paragraphs will surely make the reader a much better investor. We believe the most important takeaways could be as follows:

• Do not categorise stocks into growth and value types. A high P/E or a high price to cash flow stock is not necessarily a growth stock. A low P/E or a low price to cash flow stock is not necessarily a value stock either. 
• Growth in profits will have little role in determining value. It is the amount of capital used that will mostly determine value. Lower the capital used to achieve a certain level of growth, higher the intrinsic value. 
• There have been industries where the growth has been very good but the capital consumed has been so huge, that the net effect on value has been negative. Example - US airlines. 
• Hence, steer clear of sectors and companies where profits grow at fast clip but the return on capital employed are not enough to even cover the cost of capital.
  
  
  
  
  http://www.equitymaster.com/detail.asp?date=12/20/2007&story=2

Buffett (1992): Short-term market forecasts are poison and worthless.

Short-term market forecasts are poison and worthless. Over the long-run, share prices have to follow growth in earnings and anything more could result in a sharp correction.




Warren Buffett's 1992 letter to shareholders discussed his thoughts on issuing shares. Let us see what other nuggets he has to offer.

We have for long been a supporter of making long-term forecasts with respect to investing and we are glad that we are in extremely good company. For even the master thinks likewise and this is what he has to say on the issue.

"We've long felt that the only value of stock forecasters is to make fortunetellers look good. Even now, Charlie and I continue to believe that 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. However, it is clear that stocks cannot forever overperform their underlying businesses, as they have so dramatically done for some time, and that fact makes us quite confident of our forecast that the rewards from investing in stocks over the next decade will be significantly smaller than they were in the last. "

The above lines were most likely written by the master in the early days of 1993, a year which was bang in the middle of the best ever 17 year period in the US stock market history i.e. the years between 1981 and 1998. However, this period did not coincide with a similar growth in the US economy. Infact, the best ever stretch for the US economy was a 17-year stretch, which started around 17 year before 1981 and ended exactly in 1981. Courtesy this economic buoyancy and the subsequent lowering of interest rates, the corporate profits started looking up and they too enjoyed one of their best runs ever. Thus, a period of buoyant GDP growth was followed by a period of strong corporate profit growth, which in turn led to increase in share prices. However, share prices grew the fastest because they not only had to grow in line with the corporate profits but also had to play catch up to the economic growth that was witnessed between 1964 and 1981.

Another extremely important factor that led to a more than 10 fold jump in index levels in the period under discussion had psychological origins rather than economic. Investors have an uncanny knack of projecting the present scenario far into the future. And it is this very habit that made them believe that stock prices would continue to rise at the same pace. However, nothing could be further from the truth. Over the long-run, share prices have to follow growth in earnings and anything more could result in a sharp correction. Thus, while the share prices can play catch up to economic growth and corporate profits and hence can grow faster than the two for some amount of time, expecting the same to continue forever, could be a recipe for disaster. And even the master concurs.

We believe similar events are playing themselves out in the Indian stock markets with investors expecting every stock to turn out to be a multi bagger in no time. But as discussed above, this could turn out to be a proposition, which is full of risk of a permanent capital loss. Investors could do very well to remember that over the long-term share prices would follow earnings, which in turn would follow the macroeconomic GDP and this could be a very reasonable assumption to make.

http://www.equitymaster.com/detail.asp?date=12/13/2007&story=3

Buffett (1992): His thoughts on issuing shares.

His thoughts on issuing shares.  He concentrated most of his investments in companies where shareholder returns have greatly exceeded the cost of capital and where the entire need for future growth has been met by internal accruals.


Here are the investment wisdom Warren Buffett doled out through his 1992 letter to Berkshire Hathaway's shareholders.

Up front is a comment on the change in the number of shares outstanding of Berkshire Hathaway since its inception in 1964 and this we believe, is a very important message for investors who want to know how genuine wealth can be created. Investors these days are virtually fed on a diet of split and bonuses and new shares issuance, in stark contrast to the master's view on the topic. Laid out below are his comments on shares outstanding of Berkshire Hathaway and new shares issuance.

"Berkshire now has 1,152,547 shares outstanding. That compares, you will be interested to know, to 1,137,778 shares outstanding on October 1, 1964, the beginning of the fiscal year during which Buffett Partnership, Ltd. acquired control of the company."

"We have a firm policy about issuing shares of Berkshire, doing so only when we receive as much value as we give. Equal value, however, has not been easy to obtain, since we have always valued our shares highly. So be it: We wish to increase Berkshire's size only when doing that also increases the wealth of its owners."

"Those two objectives do not necessarily go hand-in-hand as an amusing but value-destroying experience in our past illustrates. On that occasion, we had a significant investment in a bank whose management was hell-bent on expansion. (Aren't they all?) When our bank wooed a smaller bank, its owner demanded a stock swap on a basis that valued the acquiree's net worth and earning power at over twice that of the acquirer's. Our management - visibly in heat - quickly capitulated. The owner of the acquiree then insisted on one other condition: "You must promise me," he said in effect, "that once our merger is done and I have become a major shareholder, you'll never again make a deal this dumb."

It is widely known and documented that Berkshire Hathaway boasts one of the best long-term track records among American corporations in increasing shareholder wealth. However, what is not widely known is the fact that during this nearly three decade long period (1964-1992), the total number of shares outstanding has increased by just over 1%! Put differently, the entire gains have come to the same set of shareholders assuming shares have not changed hands and that too by putting virtually nothing extra other than the original investment. Further, the company has not encouraged unwanted speculation by going in for a stock split or bonus issues, as these measures do nothing to improve the intrinsic values. They merely are tools in the hands of mostly dishonest managements who want to lure naïve investors by offering more shares but at a proportionately reduced price, thus leaving the overall equation unchanged.

How is it that Berkshire Hathaway has raked up returns that rank among the best but has needed very little by way of additional equity. The answer lies in the fact that the company has concentrated most of its investments in companies where shareholder returns have greatly exceeded the cost of capital and where the entire need for future growth has been met by internal accruals. Plus, the company has also made sure that it has made purchases at attractive enough prices. Clearly, investors could do themselves a world of good if they adhere to these basic principles and not get caught in companies, which consistently require additional equity for growth or which issue bonuses or stock-splits to artificially shore up the intrinsic value. For as the master says that even a dormant savings account can lead to higher returns if supplied with more money. The idea is to generate more than one can invest for future growth.

http://www.equitymaster.com/detail.asp?date=12/7/2007&story=3

Buffett (1991): Better to look for stable businesses run by competent people (the superstars) available at attractive prices.

Better to look for stable businesses run by competent people (the superstars) available at attractive prices than trying to look out for companies possessing the next revolutionary product or a service.




In his letter in 1991, Warren Buffett explained the difference between a 'business' and a 'franchise'. Continuing with the letter from the same year, let us see what other wisdom he has to offer.

With the kind of fortune that the master has amassed over the years, one could be forgiven for thinking him as rather infallible and the one fully capable of identifying the next big industry or the next big multi-bagger. However, this myth is easily demolished in the master's following comments from the 1991 letter.

"Typically, our most egregious mistakes fall in the omission, rather than the commission, category. That may spare Charlie and me some embarrassment, since you don't see these errors; but their invisibility does not reduce their cost. In this mea culpa, I am not talking about missing out on some company that depends upon an esoteric invention (such as Xerox), high-technology (Apple), or even brilliant merchandising (Wal-Mart). We will never develop the competence to spot such businesses early. Instead I refer to business situations that Charlie and I can understand and that seem clearly attractive - but in which we nevertheless end up sucking our thumbs rather than buying."

There are two things that clearly stand out from the master's above quote. 

• One is his ability to flawlessly identify his circle of competence and
• the second, his objectivity, from which comes his rare trait of accepting one's own mistake and working to eliminate it.

For those investors who believe that big fortune usually comes from identifying the next big thing or the next wave, they must have been surely forced to think again after coming face to face with the master's candid admission that he will never develop the competence to identify say the next 'Microsoft' or 'Pfizer' or how about the next 'Infosys' or the next 'Ranbaxy'. Indeed, outside one's industry of knowledge, it becomes very difficult to identify the next multi-bagger as it is just not high growth potential but a lot of other factors that go into making a highly successful company. In fact, even within one's industry of knowledge, it may prove to be a tough nut to crack.

So, if not the next multi-baggers, then how else can one become a successful long-term investor? The answer could lie in the master's quote from the same letter and given below.

"We continually search for large businesses with understandable, enduring and mouth-watering economics that are run by able and shareholder-oriented managements. This focus doesn't guarantee results: We both have to buy at a sensible price and get business performance from our companies that validate our assessment. But this investment approach - searching for the superstars - offers us our only chance for real success. Charlie and I are simply not smart enough, considering the large sums we work with, to get great results by adroitly buying and selling portions of far-from-great businesses. Nor do we think many others can achieve long-term investment success by flitting from flower to flower."

Thus, in investing as in other walks of life, easy does it. Hence, look around for stable businesses run by competent people and available at attractive prices. Trust us, it is much better than trying to look out for companies possessing the next revolutionary product or a service.

http://www.equitymaster.com/detail.asp?date=11/29/2007&story=3

Buffett (1991): Invest in the company possessing characteristics of a 'franchise'.

In Warren Buffett's 1991 letter to shareholders, he threw some light on his concept of 'look-through' earnings and how one should build a long-term portfolio based on it. This week, let us see what further investment insight the master has up his sleeves in the remainder of the letter from the same year.

In the 1991 letter, while discussing his investments in the media sector, the master delivers yet another gem of an advice that can go a long way towards helping conduct a very good qualitative analyses of companies. Based on his enormous experience in analysing companies, the master classifies firms broadly into two main types, 

• a business and 
• a franchise 

and believes that many operations fall in some middle ground and can best be described as weak franchises or strong businesses. This is what he has to say on the characteristics of each of them:

"An economic franchise arises from a product or service that: 

• (1) is needed or desired, 
• (2) is thought by its customers to have no close substitute, and 
• (3) is not subject to price regulation. 

The existence of all three conditions will be demonstrated by a company's ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital.

• Moreover, franchises can tolerate mismanagement. 
• Inept managers may diminish a franchise's profitability, but they cannot inflict mortal damage.

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. 
• And a business, unlike a franchise, can be killed by poor management."

We believe equity investors can do themselves a world of good by taking the above advice to heart and using them in their analysis. If one were to visualise the financials of a company possessing characteristics of a 'franchise', the company that emerges is the one with a 

• consistent long-term growth in revenues (the master says that a 'franchise' should have a product or a service that is needed or desired with no close substitutes) and 
• high and stable margins, arising from the pricing power that the master mentioned, 
• thus leading to a similar rise in earnings as the topline.

On the other hand, a 'business' would be 

• an operation with erratic growth in earnings owing to frequent demand-supply imbalances or 
• a company with a continuous decline after a period of strong growth owing to the competition playing catching up.

Thus, if an investor approaches the analysis of a firm armed with these tools or with the characteristics firmly ingrained into their brains, then we believe he should be able to weed out a lot of bad companies by simply glancing through their financials of the past few years and save considerable time in the process. Further, as the master has said that since a bad management cannot permanently dent the profitability of a franchise, turbulent times in such firms could be used as an opportunity for entering at attractive levels. It should, however, be borne in mind that the master is also of the opinion that most companies lie between the two definitions and hence, one needs to exercise utmost caution before committing a substantial sum towards a so-called 'franchise'.

http://www.equitymaster.com/detail.asp?date=11/22/2007&story=3

Buffett (1991): Highlight a simple fact that the probability of success in investing increases manifold if one is focused on building a portfolio that comprises of companies with the best earnings growth potential from a 10-year perspective.

We saw how Warren Buffett gained significantly from the phenomenon of 'double-dip' that engulfed two of his investment vehicle's best holdings and how we as investors, stand to benefit from the same. In the following write-up, let us see what other tricks the master has up his sleeve through the remainder of his 1991 letter to his shareholders.

"We believe that investors can benefit by focusing on their own look-through earnings. To calculate these, they should determine the underlying earnings attributable to the shares they hold in their portfolio and total these. The goal of each investor should be to create a portfolio (in effect, a "company") that will deliver him or her the highest possible look-through earnings a decade or so from now.

An approach of this kind will force the investor to think about long-term business prospects rather than short-term stock market prospects, a perspective likely to improve results. It's true, of course, that, in the long run, the scoreboard for investment decisions is market price. But prices will be determined by future earnings. In investing, just as in baseball, to put runs on the scoreboard one must watch the playing field, not the scoreboard."

Yet again, the master's crystal-clear thinking and his ability to draw parallels between investing and other fields shines through in the above quote. The master is trying to highlight a simple fact that the probability of success in investing increases manifold if one is focused on building a portfolio that comprises of companies with the best earnings growth potential from a 10-year perspective. However, this is easier said than done. The attention of a multitude of investors in the stock markets is focused on the stock price rather than the underlying earnings. These gullible sets of investors seem to confuse between cause and effect in investing. One must never forget the fact that it is the earnings that drive the returns in the stock markets and not the prices alone. Thus, any strong jump in prices without a concomitant rise in earnings should be viewed with caution.

However, if the trend in the Indian stock market these days is any indication, investors seem to be turning a blind eye towards earnings growth and are buying into equities with promising growth prospects but very little actual earnings to justify the price rise. The risk of indulging in such practices becomes clear when one considers the tech mania of the late 1990s. In anticipation of strong earnings, investors had bid up the price of a lot of tech stocks to such levels that when the earnings failed to meet the lofty expectations, prices crashed, resulting into huge capital erosion. But alas, the investor memory seems to be very short and a similar event is waiting to be played out, although this time in some other sectors.

Hence, one would do well to heed to the master's advice and try and focus not on the stock prices but the underlying earnings. Further, the master is also in favour of having a 10 year view so that the tendency of investors to invest based on a short term view of things gets nipped in the bud and there emerges a portfolio, having companies with a proven track record and a strong and credible management team at the helm.

http://www.equitymaster.com/detail.asp?date=11/15/2007&story=2

Buffett (1991): Recognise the enormous benefit of the 'double-dip' benefit. Pay a reasonable multiple despite high growth rates.

In Warren Buffett's 1990 letter to shareholders, he touched upon his fondness for doing business in pessimistic times, mainly for the prices they provide. Let us look what the master has to impart in terms of investment wisdom in his 1991 letter to shareholders.

"Coca-Cola and Gillette are two of the best companies in the world and we expect their earnings to grow at hefty rates in the years ahead. Over time, also, the value of our holdings in these stocks should grow in rough proportion. Last year, however, the valuations of these two companies rose far faster than their earnings. In effect, we got a double-dip benefit, delivered partly by the excellent earnings growth and even more so by the market's reappraisal of these stocks. We believe this reappraisal was warranted. But it can't recur annually: We'll have to settle for a single dip in the future."

The master's above-mentioned quote has been put up not to extol the virtues of the two companies but instead to drive home the enormous advantage of the 'double-dip' benefit that he has mentioned at the end of the paragraph. In the stock markets, it is very important to pay a reasonable multiple to the earnings of a company because if you overpay and if the multiples contract despite the high growth rates enjoyed by the company, then the overall returns stand diluted a bit. In fact, it can even lead to negative returns if the multiples contract to a great extent. On the other hand, investing in even a moderately growing company can lead to attractive returns if the multiples are low.

Imagine a company 'A' having a P/E of 25 and a company 'B' having a P/E of 10. Company 'A' is a high growth company, growing its profits by 20% per year and company 'B' is a relatively low growth company growing its profits annually by 12%. Now, two years down the line, because of 'A's growth rate, if its P/E were to come down to 20 and 'B's were to rise up to 12, then we would have in the case of 'B' what is known as a double dip effect. 'B' has benefited not only from the growth but also from the multiple expansion, resulting into returns in the range of 23% CAGR. 'A' on the other hand, despite its high earnings growth has helped earn its investors a return of just 7.3% CAGR. The main culprit here was the contraction in multiples of 'A', which fell to 20 from a high of 25.

This analysis could easily lead to one of the most important investment lessons and that is to pay a reasonable multiple despite high growth rates. For if there is a contraction, all the benefits from high growth rates go down the drain. Little wonder, the master has always insisted upon an adequate margin of safety, which if put differently, is nothing but buying a stock at multiples, which leave ample room for expansion and where chances of contraction are low.

If one were to apply the above lesson to the events playing out in the Indian stock markets currently, then it becomes clear that while the robust economic growth would continue to drive the growth in earnings of companies, most of the good quality companies are trading at multiples, which do not leave much room for expansion. In fact, if anything, the probability of the multiples coming down for quite a few companies is on the higher side, thus diluting the impact of high growth to a significant extent. Thus, we would advice investors to pay heed to the master and wait patiently for the multiples to come down to levels, where the benefits of the 'double dip' effect become apparent.

http://www.equitymaster.com/detail.asp?date=11/2/2007&story=4