The Return of the
by John Price
permission from Investor Journal, August, 1998)
friend told me that on a recent exam she was asked to explain why Warren Buffett says that diversification is a protection against
ignorance and that it makes very little sense for those who know what they are
doing. Based on a discussion she had with a stock analyst a few days prior to
the exam, she answered
roughly as follows. Buffett could buy in such large
amounts and had such a following that what ever he bought would go up in price.
Then he would sell and take a huge profit. What grade would you give that
of the 11,000 people crowding into the Aksarben
Stadium in Omaha Nebraska on May 4, 1998, for the annual
meeting of Berkshire Hathaway, the company led by Warren Buffett,
would have committed such a blunder. To a person, they knew that Buffett patiently waits until Mr.
Market offers to sell a great company with predictable earnings growth at a
discount price. Then Buffett buys all that he can
afford with the assumption that he will
hold it for life.
such a simple-minded strategy really give worthwhile returns? Once again, ask
those who attended the meeting. Many would know that when Buffett
took over Berkshire Hathaway in 1965, it was trading at $18 per share. Using it
as a vehicle for purchasing and investing in other companies, he has guided it
to the level where it is now trading at $70,000 per share, an annual return of
28 percent. Others would know simply that since they bought stock in this
former New England textile company, it has
been going up like clockwork in both share price and equity per share.
one else comes close to Buffett’s record over such an
extended period covering every type of bull and bear market. He is also unique
in that this has been accomplished without the use of derivatives, hostile
takeovers and leveraged buyouts.
dealing with the business in five minutes, Buffett
opened the meeting to questions. For almost six hours he told stories, joked and
munched on See’s Candies, while answering question after question with care,
relevance and wisdom. Many questions were also dealt with by Charlie Munger, the Vice Chairman of Berkshire Hathaway. The
following is a selection of the answers given by this twosome fairly much taken
straight from my notes. Enjoy!
- Avoid stocks with low returns on
equity and capital.
is the enemy of poor businesses, the friend of good businesses.
a poor business you may be lucky in that you pick the time that it gets
taken over. However, it is no fun to own stock in a company in which you
hope it liquidates before it goes bankrupt.
"cigar butts," but we have a had a lot
of soggy butts in our time.
presented with a new company, we can say "no" within 10 seconds.
Technology does not
get through our filter.
central role is (1) to motivate the chairmen of our companies to keep
working even though they are already very rich, and (2) to allocate
- Buy stocks that you never want to
sell; when you get a good business, buy for life.
- Ideal purchase: buy more of what
you already like and have because the price is right.
is the most important business at Berkshire Hathaway.
campaign spending is an underpriced commodity, it needs legislation to limit it.
- Berkshire Hathaway gets a 20 to
30% return on equity.
Welch (CEO of General Electric) gave his secret of life—go
where the competition is weak. How do you beat Bobby Fischer?
Play him at anything but chess.
Mae and Freddie Mac could be hurt by rising interest rates but not nearly
as much as people might think.
What keeps you awake at night? I don’t worry. We do the best we can. We
don’t predict currents—just how different fish will swim in different
Cola is the best large business in the world; amongst other things, it set
the trend for a company
to buy back its own stock.
there a danger of Japan
selling the U.S. Treasuries that it owns? When you ask such questions,
always follow up with "and then what?" If Japan sold
a billion dollars of U.S. Treasuries, what would they do with the money?
They would have to invest in other U.S. securities.
are two questions managers of public companies must ask. (1) Do you keep
the earnings or return them to the shareholders. (2) With the portion that
you keep, what do you do with it?
- Not many
analysts recommend Berkshire
Hathaway—perhaps because it is not the stock for them to get rich on.
to selecting companies. (1) We start by only
looking at companies we understand. (2) We observe whether or not the
management is telling us the truth in the Annual Report and other
publications. Are they the things we would want to know if we were buying
100% of the company. We avoid companies with
annual reports full of PR gobbledygook. We want to be able to read the
report and know the company better at the end.
Annual Report of Coca Cola is an enormously informative document. We first
bought Coca Cola on the basis of its Reports and had no discussions with its
for candid, clear, coherent prose. If a business has a problem, we would
like to know about it. Honesty and openness is the best policy. We would
like to see announcements at board meetings along the lines of "this
is a very serious problem and we have no idea how to solve it."
of the use of options and warrants, we estimate earnings for many
companies could be 10% or more lower than what
Graham was a wonderful teacher and said that you don’t have to be right
about every company. If I [Munger] taught a
course on company evaluation, I would ask the following question on the
exam, "Evaluate the following internet company." Anyone who gave
an answer would be flunked.
- Current factors influencing market
prices: (1) return on equity, (2) low interest rates, (3)
valid criticism is that we should have bought more shares of the companies
we already own; perhaps we missed the boat in some cases. Also probably we
have issued shares that we shouldn’t have.
think that the demand for silver exceeds the supply by approximately 150
million ounces per year.
value: present value of future cash that can be taken out of the business.
It easy to calculate for Coca Cola, but very difficult for Intel.
various internal models to deal with reality. One model is not enough:
"To a man with a hammer, every problem looks like a nail." [Munger]
try to assess managers as to whether they love the business or the money.
- Do not mind paying a manager a lot
of money for good performance but I am bothered by mediocre managers
getting large sums of money. Unfortunately the system
feeds on itself and there is not much that you can do to correct this
problem. The original Vanderbilt didn’t take any salary. These high
management salaries have a pernicious effect.
- Can have a circle of competence
for a particular industry, but not a circle of competence for individual
companies within the industry. It easy to say that the manufacturing of
PCs will grow enormously over the next decade, but hard to say which
company will dominate.
have decentralized Berkshire Hathaway to the point of abdication. The only
thing we have centralized is money.
future cash flows at the long treasury rate. Businesses get credit for
free cash. With the best businesses, you don’t need to keep putting in
is the art of putting in cash now to get more cash later on.
[earnings before interest, taxes, depreciation and amortization] is a nonsense
figure; it is absolute folly to take any notice of it.
- To understand a company,
understand its products, its competition, and its earning power.
- The best way to teach finance is
to focus on easy cases. For example, in 1904 anyone could see that NCR was
a wonderful company.
like homey, Norman Rockwell types of companies.
all the accounting you can.
best book on my investment methods
is by Larry Cunningham. He has done a first class job of organizing my
letters to shareholders. If I had to pick a single book, this would
probably be the one.
would be worried if I sold a stock at the top of the market because it
would mean that I would be practicing the "greater fool" theory.
is instructive to do post-mortems, but don’t get too carried away.
principle is to leave enough money for your children that they can do
anything they want, but not enough so that they can do nothing.
- Volume, price actions, RSI have no
place in our calculations.
charges are a good indication of the required capital expenditures. Avoid companies that have
to spend like crazy just to stay in competition.
businesses throw up easy questions for the managers and the board, bad businesses throw up tough questions.
- We are willing
to wait indefinitely for the right price for the right stock.
can’t do too much, but you should be interested in the company in the
first place. It might form the last 10-20 per cent of the analysis. If it
looks like a seven foot hurdle to start with, don’t touch it.
worry about risk the way it is taught at Wharton. Risk is a go/no go signal for us—if it has
risk, we just don’t go ahead. We don’t discount the future cash flows a 9%
or 10%; we use the U.S.
treasury rate. We try to deal with things about which we are quite
certain. You can’t compensate for risk by using a high discount rate.
don’t worry about volatility, if we are confident about the business. For example,
Post went down by 50% after we bought it; it was a volatile stock, but not
a volatile business.
- The best criterion is to buy
businesses on the assumption that you will hold them for life.
Queen [recently purchased by Berkshire Hathaway] is a lot different than
McDonalds. For example, it employs a lot less capital. Nevertheless,
McDonald’s still gets a good return on its capital.
don’t mind paying taxes. It is much better on this side than to be on the
other side receiving government assistance.
Mousketeers was never this much fun, even though back
then we got to wear big ears.
More Buffett principles can be found in the book
"The Essays of Warren Buffett:
Lessons for Corporate America" by Larry Cunningham which Buffett recommends.