“What is the best available source to understand the concept of value investing in stock market?”
If you ask the above question to a room full of top value investors around the world, I believe almost all of them would say “Warren Buffett annual letters to his Limited Partners and Shareholders.” (1957-2018).
Like many stock market enthusiasts, I too read them all.
Made my notes on them.
And referred to them many times.
Over and over again.
One thing which struck me was the evolution of Warren Buffett as an investor in that long period spanning more than six decades.
We, at SSIAS, have taken up this project of dividing all the letters in to six parts representing six decades of Buffett’s investment journey. For our readers convenience, we’ve put together an illustrated version of Buffett’s letters (1957-1966). Please click here to download it.
In this post we aim to find the eight big learnings from the first decade –“Warren Buffett- The Benjamin Graham Investor”
1. A Definitive Goal
Maximum Long term Growth – Minimum risk of permanent loss- Continuous investment in equities.
Having a defined goal is the first step towards success. And when you have the same shared goal with your stakeholders it makes your job clearer and makes you more accountable. This is what Mr. Buffett in his letter dated 18th January, 1965 writes —
However, I believe both our partners and their stockholders feel their managements are seeking the same goal – the maximum long term average return on capital obtainable with the minimum risk of permanent loss consistent with a program of continuous investment in equities.
Any investor or fund manager, is better off defining an investment goal first. The next step should be to communicate it to oneself and also to the stakeholders. This action brings clarity of thought and eventually better execution.
2. The Joys of Compounding:
In his letter dated 18th January, 1963, Buffett says this:
I have it from unreliable sources that the cost of the voyage Isabella originally underwrote for Columbus was approximately $30,000. This has been considered at least a moderately successful utilization of venture capital. Without attempting to evaluate the psychic income derived from finding a new hemisphere, it must be pointed out that even had squatter’s rights prevailed, the whole deal was not exactly another IBM. Figured very roughly, the $30,000 invested at 4% compounded annually would have amounted to something like $2,000,000,000,000 (that’s $2 trillion for those of you who are not government statisticians) by 1962. Historical apologists for the Indians of Manhattan may find refuge in similar calculations. Such fanciful geometric progressions illustrate the value of either living a long time, or compounding your money at a decent rate. I have nothing particularly helpful to say on the former point. The following table indicates the compounded value of $100,000 at 5%, 10% and 15% for 10, 20 and 30 years. It is always startling to see how relatively small differences in rates add up to very significant sums over a period of years. That is why, even though we are shooting for more, we feel that a few percentage points advantage over the Dow is a very worthwhile achievement. It can mean a lot of dollars over a decade or two.
|
|
5% |
10% |
15% |
|
10 Years |
$162,899 |
$259,374 |
$404,553 |
|
20 Years |
$265,328 |
$672,748 |
$1,636,640 |
|
30 Years |
$432,191 |
$1,744,930 |
$6,621,140 |
From the above writings, Buffett makes two major points about compounding.
Firstly, compounding works wonder as the time period goes on increasing. So, even if the rate of compounding is not high, if you stay invested for multi-decades, you would end up having a lot of wealth.
Secondly, only a few percentage point difference in the rate of compounding makes a huge change over long periods. The above table validates that point. Hence, as a long term investor you must always try to go for it.
3. Minimum Five Year performance:
This is what Buffett says in his letter in July, 1961:
My own thinking is much more geared to five year performance, preferably with tests of relative results in both strong and weak markets.
Our long term vision often gets blurred with what is happening in the short term. We lose our ability to think beyond the next few quarterly results. When we react to short term performance and try to build rules around it, our long term performance suffers a great deal. No investment style is bullet-proof. All styles have their strengths and weaknesses which only get exposed when a complete cycle of strong and weak markets have been witnessed. Hence a simple rule to go by is:
“Do not get too much excited (positively or negatively) by short term performance.”
4. Conventional Vs Conservative
Buffett has a very unique way of distinguishing between conventional and conservative behavior. I produce some of his commentary on conservatism below:
“There is nothing at all conservative, in my opinion, about speculating as to just how high a multiplier a greedy and capricious public will put on earnings. You will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you…. You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason… I might add that in no way does the fact that our portfolio is not conventional prove that we are more conservative or less conservative than standard methods of investing. This can only be determined by examining the methods or examining the results… I feel the most objective test as to just how conservative our manner of investing is arises through evaluation of performance in down markets.” (The Question of Conservatism, 1961 Letter)
As in life so also in investing, we often find solace in finding more people like us. When we see more people buying stocks which we own, we quickly assume that our investment thesis is correct. Similarly, when we buy a stock and it falls 20-30%, we quickly assume there is a fault in our thesis. Hence, as investors, if we have to progress from the conventional behavior to the conservative one, we have to spend considerable time finding facts and develop our independent reasoning backed by logic.
5. Why many investment firms fail
Buffett through his letters have spoken about investment performance of institutional fund managers in USA. He meticulously lists the reasons why most investment firms fail to outperform the market. It pays to go read his commentary and learn and eventually evolve as a better investor. The commentary below (1963 Letter) explains it the best:
Within their institutional framework and handling the many billions of dollars involved, the results achieved are the only ones attainable. To behave unconventionally within this framework is extremely difficult. Therefore, the collective record of such investment media is necessarily tied to the record of corporate America. Their merits, except in the unusual case, do not lie in superior results or greater resistance to decline in value. Rather, I feel they earn their keep by the ease of handling, the freedom from decision making and the automatic diversification they provide, plus, perhaps most important, the insulation afforded from temptation to practice patently inferior techniques which seem to entice so many world-be investors.
6. Primary attention should be to spot undervalued securities and not market analysis.
Buffett has been an advocate of spending all energy in finding undervalued securities. He does not want to waste too much time in understanding the macro scenario. Please note that during these times he was primarily looking for “Undervalued Securities” and not “Great Businesses.” He made it very clear in his communication about his investment style. It is simple clear and precise. In his 1958 letter, Buffett writes —
I make no attempt to forecast the general market – my efforts are devoted to finding undervalued securities. However, I do believe that widespread public belief in the inevitability of profits from investment in stocks will lead to eventual trouble. Should this occur, prices, but not intrinsic values in my opinion, of even undervalued securities can be expected to be substantially affected.
7. Generals, Work Outs & Controls
Buffett had broken down his investment into three categories which he explained in his 1961 letter. We produce below some of the extracts for our understanding:
a. The first section consists of generally undervalued securities (hereinafter called “generals”) where we have nothing to say about corporate policies and no timetable as to when the undervaluation may correct itself. Over the years, this has been our largest category of investment, and more money has been made here than in either of the other categories. We usually have fairly large positions (5% to 10% of our total assets) in each of five or six generals, with smaller positions in another ten or fifteen. Sometimes these work out very fast; many times they take years. It is difficult at the time of purchase to know any specific reason why they should appreciate in price. However, because of this lack of glamour or anything pending which might create immediate favorable market action, they are available at very cheap prices.
b. Our second category consists of “work-outs.” These are securities whose financial results depend on corporate action rather than supply and demand factors created by buyers and sellers of securities. In other words, they are securities with a timetable where we can predict, within reasonable error limits, when we will get how much and what might upset the applecart. Corporate events such as mergers, liquidations, reorganizations, spin-offs, etc., lead to work-outs. An important source in recent years has been sell-outs by oil producers to major integrated oil companies. This category will produce reasonably stable earnings from year to year, to a large extent irrespective of the course of the Dow.
c. The final category is “control” situations where we either control the company or take a very large position and attempt to influence policies of the company. Such operations should definitely be measured on the basis of several years. In a given year, they may produce nothing as it is usually to our advantage to have the stock be stagnant market-wise for a long period while we are acquiring it. These situations, too, have relatively little in common with the behavior of the Dow. Sometimes, of course, we buy into a general with the thought in mind that it might develop into a control situation. If the price remains low enough for a long period, this might very well happen. If it moves up before we have a substantial percentage of the company’s stock, we sell at higher levels and complete a successful general operation. We are presently acquiring stock in what may turn out to be control situations several years hence.
The above process and classification explains how Buffett managed to handsomely beat the stock indices by a wide margin consistently in his early years of investing. The above strategy is worth emulating. Of course, one cannot simply copy it in entirety. However, we can get inspired and think on similar lines when we start our investment career.
8. Concentrate on What should happen and NOT When it should happen
In the 1966 letter, Buffett says this:
Ground Rule No.6 (from our November packet) says: “I am not in the business of predicting general stock market or business fluctuations. If you think I can do this, or think it is essential to an investment program, you should not be in the partnership.” Of course, this rule can be attacked as fuzzy, complex, ambiguous, vague, etc. Nevertheless, I think the point is well understood by the great majority of our partners. We don’t buy and sell stocks based upon what other people think the stock market is going to do (I never have an opinion) but rather upon what we think the company is going to do. The course of the stock market will determine, to a great degree, when we will be right, but the accuracy of our analysis of the company will largely determine whether we will be right. In other words, we tend to concentrate on what should happen, not when it should happen.
The above commentary is so simple and yet so profound. We spend so much time thinking about the stock market directions and short-term performance. We have enough data to prove that timing the stock market is a futile exercise, however, still we hardly get over that psyche of projecting the market movements rather than thinking about company performance.
Investing is best when it is for the long term. Everyone knows it and speaks about it all the time. Only a very small set of investors or fund managers actually follow it. We, at Smart Sync services, through our various initiatives, try to repeatedly inform our clients and readers about the merits of investing for the long term. Learnings from Warren Buffett is one such initiative.
We have compiled an illustrated version of Buffett’s letter. You can download it from here.
