How famous is Warren Buffett? So famous that when I recently referred to Buffett as the “richest man in the world” while talking to my wife, my 7-year-old son corrected me.
“Dad, he’s the second richest man in the world.”
The world’s best-known investor is in the spotlight again, this time as the subject of an HBO film. “Becoming Warren Buffett” is a rich biopic detailing how an ambitious, numbers-obsessed boy from Nebraska became one of the world’s richest and most highly regarded investors. But viewers looking for investing tips may be disappointed.
The documentary doesn’t reveal much about the stock market titan’s financial philosophy. Indeed, after watching it you might think Buffett made his money simply by being a good guy – by earning people’s trust through honest dealing and treating folks respectfully.
Fortunately, Buffett himself offers a glimpse of his financial thinking every year in a letter to shareholders of his holding company, Berkshire Hathaway. The current missive is worth a read but runs about thirty pages. For those looking for an abbreviated version, here are the top five takeaways from Buffett’s annual shareholder letter:
1. Moats – A strong competitive advantage can act as a moat defending a company against rivals. And there is no competitive advantage stronger than efficiency. When a business operates at a lower cost base than its rivals, it can capture competitors’ customers by underpricing, while at the same time generating wider margins and higher profitability. Other moats include strong brand loyalty (Apple) and lots of patents (pharmaceutical companies).
Buffett explains in this year’s letter that Berkshire Hathaway’s auto-insurance unit, Geico, offers a real-life demonstration of these forces in action. Savings matter to families shopping for auto insurance, and only a low-cost operation can deliver substantial savings. Geico’s low-cost structure creates a trench that competitors can’t cross, leaving the company to gobble up market share year after year.
2. Company share buybacks – Tepid economic growth has led companies lacking in confidence to allocate excess earnings into share repurchases, instead of business investments. Theoretically, this approach can work; stock buybacks are just another avenue for companies to return capital to shareholders. And when done at the right price, the buybacks can add value to existing shareholders’ stakes.
But, once again in life, theory is often different from practice. Buffett notes in this year’s letter that some companies trend towards ignoring this nuance, and instead repurchase stock irrespective of price. Big mistake, according to Buffet. His call? Before discussing any repurchase, a CEO and the board should jointly declare that “what is smart at one price is stupid at another.”
3. Buffett’s numbers don’t lie – Having always prided himself as being a straight shooter, the 86-year-old billionaire consistently calls things as he sees them. Never has Buffet tried to inflate the performance of Berkshire Hathaway through accounting adjustments that exclude temporary, but nevertheless real, costs. Much to Buffett’s chagrin, many companies do this these days when reporting “adjusted earnings.”
Buffett says the reason he looks at GAAP numbers from the past is to make estimates about the future. When management regularly attempts to wave away very real costs by highlighting “adjusted per-share earnings,” Buffett gets nervous, to say the least.
4. Regarding Holding Periods – Flip to page 19 of Buffett’s latest letter and scan the list of Berkshire Hathaway’s major stock holdings. See a glaring absence there? Oh yeah, where’s Wal-Mart?
Back in 2003, at Berkshire’s annual meeting, Buffett was asked what his biggest mistake was in recent years. His response was simple: Failing to invest in Wal-Mart. The cost of the mistake? In the ballpark of $10 billion. Two years later, in 2005, Buffett tried to remedy this matter by establishing a major position in the discount retailer. And he was successful; by 2016, Berkshire’s stake in Wal-Mart was worth nearly $6 billion.
But that stake is no more. This has given some investors cause to question Buffett’s sincerity when he says his favorite holding period is “forever.” But, as Buffett clarified in this year’s letter, this rule applies to the whole companies that Berkshire owns, not its stakes in marketable securities. He went on to say that he wants owners to understand that he regards any marketable security as available for sale, however unlikely such a sale may now seem.
5. Regarding our unsettled world – Several high-profile investors and institutions have recently issued warnings that stocks are approaching unsustainable levels. This news follows the market’s surge in the wake of last year’s presidential election. In fact, David Kostin, chief U.S. equity strategist at Goldman Sachs, said in a recent report that financial market “reconciliation” lies ahead.
Buffett’s stance? He agrees and disagrees. While admitting that the market is certain to experience major declines, Buffett believes it’s impossible to predict when any declines will occur. At the same time, Buffett urges investors see any decline as an opportunity.
According to Buffet, widespread fear is an investor’s friend and an individual’s enemy. Fear creates bargain purchases, which are great for investors. Similarly, investors who avoid high and unnecessary costs and simply wait patiently for an extended period with a collection of large, conservatively financed American businesses will almost certainly do well.
Personal fear is unwarranted, Buffett explains. We can pour a tremendous amount of energy looking for systemic risks. But at the end of the day (and the closing bell), it’s more likely to find us.
The takeaway here is that no one – not Buffett, not economists, not the media – can predict when market panics or traumas will occur. So, keep calm and carry on.