5 ways Warren Buffett invests that you don’t Commentary: Berkshire’s shareholder letter sets ground rules
Bend it like Beckham? Not likely.
Bend it like Buffett? Go for it. Buffett even tells you how.
The building blocks of the Berkshire Hathaway BRK.A +0.36% BRK.B +0.33% investment portfolio are contained in the widely read and quotable letter to shareholders that Buffett famously writes every year. The latest letter was just published, and its 24 pages offer optimism, folksy chestnuts and practical lessons for investing in stocks — and yourself.
“American business will do fine over time,” Buffett writes. “And stocks will do well just as certainly, since their fate is tied to business performance. Periodic setbacks will occur, yes, but investors and managers are in a game that is heavily stacked in their favor.”
He adds: “Since the basic game is so favorable...the risks of being out of the game are huge compared to the risks of being in it.”
Of course, acquiring even rudimentary skill and knowledge requires a lot of practice — kicking the ball again and again. Buffett is no exception. He’s taken it to the highest level, but the seeds of his investment process can sprout on any field: Review; reinvest, reinvent — and be sure to follow Buffett’s lead and break for a root beer float or two.
Related video: How to bend it like Buffett.
1. ‘Almost’ doesn’t count
The Berkshire shareholder most disappointed with the company’s 2012 results might have been Buffett himself.
Though Berkshire finished last year $22.8 billion richer, after spending $1.3 billion to buy back stock, Buffett dismissed the performance as “subpar,” since the company’s 14.4% increase in book value was less than the 16% total return for the benchmark Standard & Poor’s 500-stock index SPX +0.56% .Read more: Buffett says $24 billion gain wasn't good enough.
“It’s our job to increase intrinsic business value...at a faster rate than the market gains of the S&P,” Buffett writes in his shareholder letter. Otherwise, he adds, an investor could simply buy a low-cost S&P 500 index fund and pocket the market’s returns.
But Buffett refuses to wallow. “We will keep our foot to the floor,” he says. “[Berkshire Vice-Chairman] Charlie [Munger] and I hope to build per-share intrinsic value by improving the earning power of our many subsidiaries, further increasing their earnings through bolt-on acquisitions, participating in the growth of our investees, repurchasing Berkshire shares at a meaningful discount...and making an occasional large acquisition. Related video: Buffett calls Berkshire’s 2012 returns ‘subpar.’
2. Believe in your best ideas
Buffett refers to American Express AXP +0.12% , Coca-Cola KO +1.11% , IBM IBM +1.76% and Wells Fargo WFC +0.54% as Berkshire’s “Big Four” investments — and he does so with undisguised pride.
“The four companies possess marvelous businesses and are run by managers who are both talented and shareholder-oriented,” Buffett writes. “We much prefer owning a non-controlling but substantial portion of a wonderful business to owning 100% of a so-so business.”Read more: 6 stocks Warren Buffett hunted in 2012.
Those two statements speak volumes. Too often, investors focus on a product or headline and don’t give enough attention to how management makes decisions and treats shareholders.
Yet without executives who create value, not destroy it, and give shareholders the respect they deserve, investors could be in for a rough ride. Related video: Warren Buffett’s six biggest stock buys of 2012.
3. Be true to your style
In his letter, Buffett says he’s been under some pressure to use Berkshire’s substantial cash hoard to pay a shareholder dividend. He says he understands people’s need for income.
Then he goes to great lengths to explain why that won’t happen as long as he’s in charge.
Buffett likes dividends — many of the stocks in Berkshire’s portfolio offer attractive payouts and have been ever more generous to shareholders over the years. But he’s convinced Berkshire can use its money in productive, value-adding ways such as reinvesting in existing holdings or making new purchases. Cash is king, and Buffett isn’t inclined to be more democratic about spending it.
“I have made plenty of mistakes in acquisitions and will make more,” Buffett writes. “Overall, however, our record is satisfactory, which means that are shareholders are far wealthier today than they would be if the funds we used for acquisitions had instead been devoted to share repurchases or dividends.”
That said, Berkshire is buying back stock when its shares sell at a discount to a conservative estimate of the company’s intrinsic value. But the company won’t pay more than 120% of that figure — Buffett has never been one to pay any price, lest he and his shareholders pay the price.
“In repurchase decisions, price is all-important,” Buffett writes. “Value is destroyed when purchases are made above intrinsic value.”Read more: Warren Buffett's 'ground rules' for investing.
4. Be open to change
Buffett at 82 has much in common with the 32-year-old bargain-hunter who built a successful private investment partnership in Omaha. For example, half a century later Buffett still searches for discounted merchandise that his mentor Benjamin Graham called “cigar butt” investments.
Yet nowadays that search is joined by two investing deputies, Todd Combs and Ted Weschler, who share the chairman’s buying and selling discipline and independently manage portions of Berkshire’s $88 billion portfolio.
Giving stock-picking authority to anyone not named Buffett is Buffett’s nod to his advanced age and concerns about the company’s future after he and Munger are no longer involved.
But that also means ceding a certain amount of control and recognizing that the portfolio won’t be a pure reflection of the Oracle of Omaha. The first such stock to cross the $1 billion threshold: satellite TV provider DirectTV DTV +1.23% .
Buffett is clearly pleased with his chosen progeny. Recently Combs and Weschler were given more money to manage — almost $5 billion apiece. “We hit the jackpot with these two,” Buffett writes. “In 2012 each outperformed the S&P by double-digit margins. They left me in the dust as well.” Related video: Buffett picks a bear for Berkshire meeting panel.
5. Be patient -- wait for your pitch
Value investors typically hold shares for years, but they also might wait years before buying.
Price is everything. “A business with terrific economics can be a bad investment if the price paid is excessive,” Buffett writes.
It also holds that a business in a declining industry can be a decent investment if the purchase price is heavily discounted.
That’s why Berkshire has been on a newspaper-buying spree, acquiring 28 daily newspapers over 15 months at a cost of $344 million. Print publications in general have been hollowed out by the Internet, which means that two newspaper devotees like Buffett and Munger can buy them on the cheap.
“Berkshire’s cash earnings from its papers will almost certainly trend downward over time,” Buffett admits. “At our cost, however, I believe these papers will meet or exceed our economic test for acquisitions.”
He adds: “At appropriate prices — and that means at a very low multiple of current earnings — we will purchase more papers of the type we like.”
Review, reinvest, reinvent — such thinking about investments has guided Buffett’s success.
“Charlie and I believe in operating with many redundant layers of liquidity,” Buffett says, “and we avoid any sort of obligation that could drain our cash in a material way. That reduces our returns in 99 years out of 100. But we will survive in the 100th while many others fail. And we will sleep well in all 100.”
6 stocks Warren Buffett hunted in 2012