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Common Stock Investments

The number of companies where Berkshire had a stake of over $100 million continued to be low in number and simple in concept. The big investment ideas is summarised by Warren Buffett as:

“We like a business with enduring competitive advantages that is run by able and owner-oriented people. When these attributes exist, and when we can make purchases at sensible prices, it is hard to go wrong.”

The performance of an investment does not depend on the complexity of the investment. If you can evaluate correctly a company that is simple to understand and enduring, the result is the same if you had correctly analysed another complex investment alternative.

Rather than try to time his purchases, Warren Buffett will determine the fair value and buy when there is a margin of safety.

It is foolish to stop buying shares in an outstanding business whose long-term future is predictable, because of short-term concerns over the economy or stock market.

Also, before buying new investments, Warren will consider adding to old ones first. If a business is attractive in the past, it could still be in the present/future.

Incidently, quite a number of the purchases that Warren Buffett made for Berkshire are what similar to what he bought many years ago as a private investor.

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In 1994, Berkshire has a networth of $11.9 billion compared to $22 million when they first started. While their investment strategies will continue to work (and there are as many good businesses as ever), it is now useless for them to make purchases that are too small.

Any investment amount worth less than $100 million won’t even be considered. As such, Berkshire’s investment universe has shrunk significantly.

One major distraction for many investors are political and economical forecasts and events.

No one could have predicted the Vietnam War, oil shocks, dissolution of the Soviet Union, resignation of a president and so on.

Despite all these events, Benjamin Graham’s principles still hold true. Some of Warren Buffett’s best purchases were made when fear about some macro event were at a peak.

Other major shocks are sure to occur in the future. These cannot be predicted with any certainty. As long as Warren Buffett can continue to identify businesses similar to what he has purchased in the past, these external surprises will have little effect on his long term results.

Share prices will continue to fluctuate; and the economy will hav its ups and downs. Over time, good businesses will continue to increase in value.

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Portfolio Turnover

If a parent company owns a subsidiary with excellent long-term economics, is it likely for the subsidiary to be sold regardless of price?

Not likely.

That is the same mindset that you, as a small investor, needs to adopt when you own a small piece of an excellent company. The worst advice you can possibly get from your broker is, “You can’t get broke taking a profit”.

$40 invested in Coke in 1919 will have grown to $3277 by the end of 1938. A fresh $40 invested at the end of 1938 would have grown to $25,000 by the end of 1993.

An investment lifetime is just too hard to make hundreds of smart decisions.

Risk – Buffett’s definition

Is it riskier to hold less stocks? Risk, as Warren Buffett defines, is “the possibility of loss or injury”.

A policy of portfolio concentration may even reduce the risk as the investor would have to think even harder about a business and its economic characteristics before he invests into it.

If you are a know-something investor who is able to understand business economics and find five to ten well-priced companies that possesses long-term competitive advantage, then diversification makes no sense for you.

It simply makes no sense as to why you would want to buy more of a company that is your 20th favorite, rather than buying more of your top choices.

The real risk that an investor must assess is whether his after-tax returns from an investment will give him at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake.

While you can’t calculate it precisely, these are the factors (in his exact words) that Warrren Buffett tells us to consider:

1) The certainty with which the long-term economic characteristics of the business can be evaluated;

2) The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows;

3) The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself;

4) The purchase price of the business;

5) The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor’s purchasing-power return is reduced from his gross return.

Risk – Academic definition

Academics like to define risk as the volatility of a stock or a portfolio of stocks compared to a large universe of stock. So, the higher the volatility (or beta), the riskier the stock.

Isn’t it absurb that if a stock suddenly suffers a massive drop in price, it’s volatility has increased and thus it has become riskier at a lower price?

The true investor welcomes volatility. In Chapter 8 of The Intelligent Investor, Benjamin Graham introduces us to Mr Market, a person who shows up every day to buy from you or sell to you.

Whatever the price of the day, you have the option of wanting or refusing to transact with Mr Market.

Now, if the prices are extremely volatile (or riskier as defined by the books), wouldn’t that offer you a chance for you to buy at irrationally low prices once in a while?

How can that be riskier for you when you are totally free to choose whether or not to transact every day?

Despite all these, you will be able to find companies with a very strong competitive moat (like Gillette or Coke) having a volatility that is similar to other run-of-the-mill companies who possess little or no competitive edge.

Equating beta or volatility with investment risks simply makes no sense. Rather, you should be looking at the business risks as given in the five factors mentioned above.

When Diversification is Appropriate

One example when wide diversification is appropriate is when you are doing arbitrage.

If a single arbitrage transaction poses significant risk, overall risk should be reduced by making other mutually independent transactions.

Just make sure that your gain, weighted for probabilities, considerably exceeds your weighted loss, and that you can commit to a number of similar but unrelated opportunities.

This is like a roulette operator who likes to see lots of action because it is favored by probabilities, but will not accept a single, huge bet.

Another example is when an investor does not understand the economics of specific businesses. In this case, he will be better off investing in a basket of stocks through an index fund.

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Value Investing

Compared to that stated 15 years ago, the only change in the equity-investing strategy of Warren Buffett is the addition of the word “very”:

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.

The question one now needs to ask is how to decide what is attractive. Unlike most analysts who choose between either a growth or value approach, Buffett feels that growth is always a component of value. The important of which can vary from negligible to large, and the effects can be from negative to positive.

The term “value investing” is also redundant as all investing seeks to buy something of value that justifies the price paid. Overpaying for something in the hope of selling it at an even higher price is not investing, but speculation.

A “value investment” is not determined in any way by its price-earnings ratio, price to book ratio or even a high dividend yield.

Neither is it determined by the growth. While most growth often has a positive impact on value, it only benefits investors when each additional dollar used to finance the growth creates more than a dollar of long-term market value.

If business returns are low, growth actually hurts the investor.

Taken from The Theory of Investment Value written in 1937 by John Burr Williams, value can be defined as:

The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.

You will notice that the same formula is used for stocks as well as bonds. An important difference to take note is that for bonds, the future cash flows can be accurately determined from the coupon rate and maturity dates. While for stocks, the future cash flows has to be estimated.

This is the part where most people can go wrong.

Berkshire overcomes this problem by:

1) Dealing only with businesses that they understand, are simple and stable in nature. The best businesses to own are those that can employ large amounts of incremental capital at very high rates of return over an extended period of time. The worst businesses to own are those that does the opposite – that is, consistently employ ever-increasing amounts of capital at very low rates of return.

2) Having a margin of safety (as strongly emphasized by Ben Graham) in the purchase price.

Using the discounted-flows-of-cash calculation, the investment that is shown to be cheapest should be brought. Other factors like growth, earnings volatility, book value wouldn’t matter at all as these would all have been factored in.

And if the calculations show that bonds are cheaper, then they should be bought instead.

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Marketable Common Stocks

The majority of Berkshire’s stock holdings remain unchanged compared to the previous year. This stay-put behavior reflects Warren Buffett’s view that the stock market serves as a relocation center at which money is moved from the active to the patient.

Because of the large sums he works with, Warren Buffett considers the “searching for the superstars” method as his only chance for real success. This method includes:

1) Searching for large businesses with understandable, enduring and mouth-watering economics.
2) Run by able and shareholder-oriented managements.
3) Buying a few of the best companies at a sensible price and holding them for the long term. He certainly would not wish to own an equal part of every business in town.

If finding great businesses and outstanding managers is so difficult, why should proven products be discarded?

His motto is: “If at first you do succeed, quit trying.

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Purchase of Marketable Securities

The selection of securities that Warren buys can be classfied under five categories: (1) long-term common stock investments, (2) medium-term fixed-income securities, (3) long-term fixed income securities, (4) short-term cash equivalents, and (5) short-term arbitrage commitments.

He has no particular bias when it comes to choosing from these categories. The aim is to achieve for the highest after-tax returns as measured by “mathematical expectation,” limiting himself always to investment alternatives that he can understand. His criteria have nothing to do with maximizing immediately reportable earnings; rather, is to maximize eventual net worth.

Common Stocks

In 1987, Mr Market was on a major rampage until Oct, when it had a sudden seizure. The net result was a gain of 2.3% for the Dow.

Many prestigious money managers now focus on what they expect other money managers to do in the days ahead, rather than on what the business will do. An extreme example of what their attitude leads to is “portfolio insurance”, where a downtick of a given magnitude automatically produces a huge sell order.

Considering that huge sums are controlled by managers following such practices, is it any surprise that markets sometimes behave in illogical fashion?

After buying a farm, would a rational owner next order his real estate agent to start selling off pieces of it whenever a neighboring property was sold at a lower price?

Such markets are ideal for any investor – small or large – so long as he sticks to his investment knitting. Volatility caused by money managers who speculate irrationally with huge sums will offer the true investor more chances to make intelligent investment moves. He can be hurt by such volatility only if he is forced, by either financial or psychological pressures, to sell at untoward times.
Mr. Market will offer us opportunities – you can be sure of that – and, when he does, we will be willing and able to participate.


Warren continues to parking most of his money in medium-term tax-exempt bonds, with an aversion to long-term bonds. Even back in 1986, he is already not optimistic about the long term future of U.S. currency due to the enormous trade deficit.

The pileup of “claim checks” in the hands of foreigners will ultimately lead to an increased pressure on the issuer to dilute their value by inflating the currency.

While recognizing the possibility that he may be wrong and that present interest rates may adequately compensate for the inflationary risk, Warren retains a general fear of long-term bonds.

Market Rumours

It is often reported in the press about Berkshire’s purchase or sale of various securities. Warren does not comment in any way on rumors, whether they are true or false. If he were to deny the incorrect reports and refuse comment on the correct ones, he would in effect be commenting on all.

His advice for anyone who wants to participate in whatever Berkshire is doing, is to simply buy the Berkshire stock!

About Debt

It is likely that Berkshire could improve its return on equity by moving to a much higher, though still conventional, debt-to-business-value ratio. It’s even more likely that we could handle such a ratio, without problems.

However, “likely” is not good enough for Warren. He wishes to be “certain”. Thus he adheres to policies – both in regard to debt and all other matters – that will allow them to achieve acceptable long-term results under extraordinarily adverse conditions, rather than optimal results under a normal range of conditions.

Good business or investment decisions will eventually lead to economic gains, even without the use of excessive leverage. However, he is willing to borrow as long as the amount does not pose a threat to Berkshire’s well being.

His strategy is to finance in anticipation of need rather than in reaction to it. A business obtains the best financial results possible by managing both sides of its balance sheet well. This means obtaining the highest-possible return on assets and the lowest-possible cost on liabilities.

It is often that opportunities for intelligent action on both fronts do not coincide. Tight money conditions, which translate into high costs for liabilities, will create the best opportunities for acquisitions, and cheap money will cause assets to be bid to the sky. Therefore, his action on the liability side should sometimes be taken independent of any action on the asset side.

This fund-first, buy-or-expand-later policy almost always penalizes near-term earnings. For example, Berkshire is now earning about 6.5% on the $250 million they recently raised at 10%, a disparity that is currently costing them about $160,000 per week.


This year’s letter started with a reiteration of something that was mentioned in the previous year’s letter. Even though undistributed and unrecorded earnings of non-controlled holdings will not be reflected in the accounts, they will eventually be translated into tangible value over the long run.

A note on general acquisition behaviour. Buffett would rather buy 10% of X company at Y per share than 100% of X at 2Y per share. Most corporate managers however, prefer just the reverse. This results in a larger empire, but poorer citizens.

There are however some dazzling exceptions and most of them fall into two major categories.

The first category involves purchase of business that are well adapted to an inflationary environment. These businesses are able to raise their price without fear of significant fear of loss of market share or unit volume. They are also able to accomodate large increases in their volume with only minor addition of investment capital.

The second category involves the mangerial superstar – people who are able to recognise businesses that are “the rare prince disguised as a toad”.

Buffett finds values most easily through the open-market purchase of fractional positions in companies with excellent business franchises and competent, honest managements.

In most cases, undistributed earnings from such companies will produce full value for Berkshire and its shareholders. If they don’t, it could be due to three reasons: (1) the management (2) the future economics of the business; or (3) the price that was paid.

There follows a lengthy discussion on “Equity Value-Added”. To justify an investment in equity, there should be additional earnings above passive investments returns. This is derived from the employment of managerial and entrepreneurial skills in conjunction with that equity capital.

Also, since an equity capital position requires additional risks, we should be getting a higher return for the risk.

When a business is able to achieve this, a dollar of each is usually valued at more than a hundred cents. Conversely, if investment returns of passive instruments are higher than the returns from a business, such a business will be valued at less than a dollar for each dollar.

The bottomline? Interest rates (an inflation rates) would and will affect the valuation of any business.

An ironic situation is that a “bad” business will usually need to retain most of it’s capital to continue operating. Consider if you have a 5% bond and current rates were about 10%. Will you take the coupons from the bond and pay hundred cents on the dollar for more 5% bonds when the same dollar will buy you a 10% bond? Yet, that is what “bad” business are doing by retaining capital. Shareholders would be better served receiving the earnings as dividends and re-investing them elsewhere.

On the other hand, a “good” business with a high return on equity should retain all it’s capital so that shareholders can earn premium returns on enhanced capital.

In the opening paragraph of this letter, there’s already a lesson. When looking at the operating earnings of any company, do not take into account the capital gains/losses of its holdings. We will want to evaluate a company based on the earnings from it’s underlying operations.

In the long run however, the aggregate gains or losses will of course be significant.

Another thing is about earnings. Most companies define record earnings as a new high in earnings per share. The point to note is that there is nothing fantastic about higher earnings if the equity base is higher! Even a dormant savings account can do the same because of compounding.

Thus, a more appropriate measure of managerial ability is the return on equity capital.

The third lesson is in the choosing of companies in correct industries. The textile operations continued to struggle even with good management while the insurance business continued to thrive even though a few major mistakes were made.

There was an interesting comment by Warren that the only products of insurance companies are promises. The policies can be copied by anyone, and there’s very little consumer differentiation to protect against competitors. In such a business, the individual managers have a greater effect on the company’s performance.

Warren also spells out his criteria for buying over businesses. The business should be (1) one that you can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price.

As most stocks would be held over the long term, do not be overly concerned with just near term earnings or recent trends in earnings when making your stock purchases. If you were buying a whole business, wouldn’t you be more concerned about the long term prospects?

Also, it makes no difference whether you are buying a minority stake or taking over the entire company. After all, you would want the present management to carry on with the wonderful job that they had been doing and not make any changes.

In fact, it is often the case that the stock market offers you chances to make your purchases at a very good (low) prices. If you were to try buying over the whole company, usually you would have to offer fair value (high price).

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