Warren Buffett’s annual letter to shareholders was released this past weekend. Like previous letters, it’s filled with several lessons and great reminders for investors. Let’s dive in.
Even the Best Investor Makes Mistakes
The final component in our GAAP figure – that ugly $11 billion write-down – is almost entirely the quantification of a mistake I made in 2016. That year, Berkshire purchased Precision Castparts (“PCC”), and I paid too much for the company. No one misled me in any way – I was simply too optimistic about PCC’s normalized profit potential…
I believe I was right in concluding that PCC would, over time, earn good returns on the net tangible assets deployed in its operations. I was wrong, however, in judging the average amount of future earnings and, consequently, wrong in my calculation of the proper price to pay for the business. PCC is far from my first error of that sort. But it’s a big one.
Every investor loves to tout their winners. Nobody likes to talk about their losers. Well, almost nobody.
The best investors talk about their losers all the time. They know investing is an imperfect game where mistakes are bound to happen.
It’s a way for them to set expectations for themselves and their shareholders or clients. Nobody bats 1,000. Not even the best investors.
It Takes is a Good Story
Investing illusions can continue for a surprisingly long time. Wall Street loves the fees that deal-making generates, and the press loves the stories that colorful promoters provide. At a point, also, the soaring price of a promoted stock can itself become the “proof” that an illusion is reality.
Eventually, of course, the party ends, and many business “emperors” are found to have no clothes. Financial history is replete with the names of famous conglomerateurs who were initially lionized as business geniuses by journalists, analysts and investment bankers, but whose creations ended up as business junkyards.
The conglomerate craze in the 1960s led to a speculative mania in the shares of companies like LTV, Litton Industries, and Teledyne. Like all manias, it began with a great story that got share prices marching higher. Acquisitions could be used to rapidly “grow” earnings.
An acquisition spree and creative accounting were all it took to for conglomerate earnings to sore and with it, share prices. But as the conglomerates got bigger, they needed more acquisitions to maintain their growth. Like all manias, it reached its limits and came to a crashing end.
Of course, history is filled with more than conglomerates that were inflated on great stories and little else. A few exist today.
The Benefit of Buybacks
The math of repurchases grinds away slowly, but can be powerful over time. The process offers a simple way for investors to own an ever-expanding portion of exceptional businesses.
Stock buybacks aren’t nearly as bad as certain misinformed people would like you to believe. In fact, buybacks can be good for existing shareholders under the right conditions.
Companies have a few options when it comes to earnings. They can reinvest earnings to grow the business, use it to pay down debt, or return it to shareholders.
There are two ways to return earnings to shareholders. Dividends are a nice but taxable option. The other option is to buy out shareholders who no longer want to own shares in the company. The remaining shareholders benefit because their ownership stake in the business grows relative to the number of shares bought back.
And when buybacks are done at a price below the fair value of the company, those dollars go further. The remaining shareholders see a second benefit in a higher stock price when the market eventually corrects its mispriced mistake.
Success stories abound throughout America. Since our country’s birth, individuals with an idea, ambition and often just a pittance of capital have succeeded beyond their dreams by creating something new or by improving the customer’s experience with something old…
Today, many people forge similar miracles throughout the world, creating a spread of prosperity that benefits all of humanity. In its brief 232 years of existence, however, there has been no incubator for unleashing human potential like America. Despite some severe interruptions, our country’s economic progress has been breathtaking.
Buffett offers a history lesson on business in the U.S., specifically how Berkshire shareholders benefited from numerous companies that were started across the country at different times. Three immediate lessons stand out.
First, the U.S. has provided a ripe environment for business startups for over a century.
Second, owning successful businesses is one of the best ways to grow your wealth.
Third, growing wealth rarely happens quickly.
A fourth, less obvious lesson, is you don’t have to start your own business to participate in the success. You don’t even have to get in early. In fact, in every business example Buffett offered, he showed up long after the business was started — sometimes decades after the fact. And he still made money.
Of course, Buffett is a unique case of investing genius. You can try to do what Buffett did but that’s a tough act to follow. Or you can take a simpler route and, for example, let an index fund do the picking for you.
…ownership of stocks is very much a “positive-sum” game. Indeed, a patient and level-headed monkey, who constructs a portfolio by throwing 50 darts at a board listing all of the S&P 500, will – over time – enjoy dividends and capital gains, just as long as it never gets tempted to make changes in its original “selections.”
Productive assets such as farms, real estate and, yes, business ownership produce wealth – lots of it. Most owners of such properties will be rewarded. All that’s required is the passage of time, an inner calm, ample diversification and a minimization of transactions and fees. Still, investors must never forget that their expenses are Wall Street’s income. And, unlike my monkey, Wall Streeters do not work for peanuts.
The point is that the stock market allows anyone to participate in the future success of American businesses. But it also allows you to speculate and gamble and jump in and out of the market dozens of times a day.
The key is to avoid the distractions that come with the day-to-day fluctuations of markets. There will always be someone selling a story that requires quick action. But it comes at a cost. It’s best to ignore it. Be patient. Growing wealth, for most people, happens slowly, over time. You can try to do it fast, but the success rate is pitifully low.
2020 Berkshire Hathaway Letter
Lessons from the 2019 Berkshire Letter
Lessons from the 2018 Berkshire Letter
Lessons from the 2017 Berkshire Letter