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The Buffett Letters
Hope you enjoyed the Super Bowl (or the commercials) if you tuned in and that you’re having a great Valentine’s Day.
I was reading the book The Essays of Warren Buffett recently which is essentially a collection of his shareholder letters. What I found interesting was that a lot of the wisdom and principles in them have stood the test of time and can be applied more generally, even to those operating or investing in other disciplines today.
So, this week, I’ll be sharing some of the key elements of wisdom contained in the letters. If you enjoy reading this, you may also enjoy a piece I wrote before on some of the lessons from Bezos’s letters.
With the volatility of stock markets, sometimes it’s easy to forget that companies, like other assets, have an intrinsic value which isn’t necessarily impacted by movements in the stock price.
Intrinsic value is basically defined as the discounted present value of the cash that can be taken out of a business during its remaining life.
Buffett places a big emphasis on intrinsic value, as at the end of the day that is the actual value of the business.
It is also the thing that management has more direct control over. While market price tends to move in correlation with in, companies can go through periods where the market price is either significantly below or above the per-share intrinsic value.
Buffett notes that ignoring price, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. This allows it to essentially compound its intrinsic value over time.
In today’s age, arguably it’s even harder to calculate intrinsic value. But with crazy market movement where stocks have gone up 5X and then down 60-80%, thinking about what the intrinsic value of a business is can be helpful to ground an investor and help them not worry about the movement in the market as much.
Buffett also often touches on the idea of Mr. Market, a concept he borrows from Ben Graham, which is a helpful way of thinking about market prices vis-a-viz the intrinsic value discussed above
Ben Graham said that one should imagine market quotations as coming from a someone named Mr. Market who is your partner in a private business.
He appears daily without fail and names a price at which he will be willing to buy from you or sell you shares in a company.
Even if the business in question might be stable over time, his price quotations may not be.
At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.
The good thing is that you can ignore Mr. Market if you want and he comes back to you the next day.
The insight contained here is that sometimes, even though the underlying business isn’t changing much from day to day, the market in aggregate can feel euphoric or depressed and overreact and raise or lower the market price to a point where it isn’t in line with the intrinsic price.
Additionally, let the operating results of the company, not the daily or yearly price quotations, help you judge your investments’ success.
As Ben Graham said:
“In the short run, the market is a voting machine but in the long run it is a weighing machine.”
As long as the company’s intrinsic value goes up at a satisfactory rate, your investment is doing well and the market will recognize it eventually over time. Sometimes, if it takes the market a while to do so, that can be a good thing, since you can buy more at a bargain price.
Margin of Safety
Margin of Safety is one of the cornerstones of the Buffett philosophy, and a way of linking the two ideas above.
Berkshire and Buffett are only interested in investments if there is a margin of safety built into it, in that there is a sufficient gap between what they believe the intrinsic value of the business is (conservatively calculated) and what the market price of the business is.
Said differently, if intrinsic value is what you are getting, and the market price determined by Mr. Market is what you are paying, Buffett only invests if the market value is sufficiently below what the estimated intrinsic value is.
Margin of Safety basically builds in a cushion to prevent some downside risk, and also allows for having higher conviction around a company.
“We insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we’re not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.”
Circle of Competence
Buffett is a big believer of sticking to what you know and understand. He uses the idea of circle of competence, referring to knowing where one’s limits of knowledge and ability lie to judge the business model and economics of businesses and staying with that circle.
“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.”
This idea helps in a few ways:
Calculating Intrinsic Value: Since Buffett is trying to determine intrinsic values which require forecasting cash flows and making assumptions which are inherently uncertain, sticking to things you understand helps you make better assumptions and estimates and get to results that you feel more confident in.
Helps avoid mistakes: If somebody is looking at something completely out of their sphere of knowledge, they are more likely to misunderstand how an industry or business works and make flawed assumptions. Sticking to areas you have knowledge in helps reduce costly mistakes.
Note that the circle of competence doesn’t mean that one doesn’t try to learn about new areas or ignore anything they don’t understand. It just means being true to yourself on what your current knowledge sphere is (which can change over time).
The circle of competence is one of the reasons Buffett has missed out on tech, but something that he is quite comfortable with, given the numerous other opportunities available to generate returns.
“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.”
Buffett views great managers as stewards of shareholder capital who think and act like owners of their business, and places an emphasis on it when evaluating investments.
“In making both control purchases and stock purchases, we try to buy not only good businesses, but ones run by high-grade, talented and likeable managers.”
A big part of what makes management great is capital allocation ability, which Buffett believes can be rare in people who make it to CEO, given its a somewhat different skillset which they may not have tackled before.
“Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch the point, it’s as if the final step for a highly-talented musician was not to perform at Carnegie Hall but, instead, to be named Chairman of the Federal Reserve.”
When it comes to Berkshire’s own appointed CEOs, Buffett gives them a simple set of principles to follow:
To run their business as if:
they are its sole owner
it is the only asset they hold
they can never sell or merge it for a hundred years.
Putting the Investment Philosophy together
The above ideas come together in Buffett’s investment philosophy, outlined succinctly below:
“We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety. We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and (d) available at a very attractive price.
(a) → staying within the circle of competence
(b) → looking for companies that can compound intrinsic value
(c) → run by great management teams
(d) → where there is a margin of safety built into the price provided by Mr. Market.
In taking the above approach, Buffet notes that Berkshire’s goal is to find an outstanding business at a sensible price, not a mediocre business at a bargain price.
“If the choice is between a questionable business at a comfortable price or a comfortable business at a questionable price, we much prefer the latter. What really gets our attention, however, is a comfortable business at a comfortable price.”
He also notes that one of the lessons he has learned is to stick with the easy and obvious than look for the difficult. In fact, he actively tries to avoid difficult business problems when evaluating opportunities for investment rather than seek them out.
After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them.
Value vs Growth
Buffett believes the distinction drawn between value and growth investing is a bit artificial. Every investment requires a calculation of value, and growth is always a component of that.
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.
When it comes to the typical value approach of low P/E ratios or high dividend yield, Buffett believes these are not enough to determine whether something is truly trading at a “value” price. Vice Versa, something could be good value, even though it has a high P/E or low dividend yield.
Similarly, growth benefits investors, but only when the business can invest incremental returns that are enticing.
Ultimately, investors want to buy assets at prices that are at a good price relative to the “value” they have. The value they have can come from “growth” in the business or based on the existing cash flows or earnings of the business.
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