Someone is sitting in the shade today because someone planted a tree a long time ago.
– Warren Buffett, January 1991
This article is about innovative money making, which true to the underlying meaning of innovation is about creative use of already existing knowledge. As the Ghaff tree in the UAE desert below brings shadows in the heat of day, true fortunes are likely to be seeded over a very long period of time. This may sound boring or worrying to today´s impatient investors but measuring both return and risk, it is likely the best strategy over time. The likely outcome of current short term patience among investors is something I wrote about in the previous article “Margin call”.
Warren Buffett, nick-named “The Sage of Omaha”, was born August 30th 1930. He is an American investor and philanthropist and he was the most successful investor of the 20th century, through his investment vehicle Berkshire Hathaway, where he is the chairman, CEO and largest shareholder. Click on the link above to see the company’s homepage. It will be a chocking experience, but very telling about the frugal Buffett, who lives in a house he bought in 1958 and drives a modest 2006 Cadillac DTS. However as he is aging the car is up for auction, with the proceeds going to a good cause.
Buffet, who consistently ranks among the world’s wealthiest people, lives a lifestyle that has not changed much since before he before he made his billions. Underlying his legend is one simple fact: Buffett is a value investor. It’s the hallmark trait of both his professional and personal success.
Value investing is an investment paradigm that derives from the ideas on investment that Benjamin Graham began teaching at Columbia Business School in 1928 and subsequently developed in his 1949 book The Intelligent Investor.
In the book, Graham argued that investors should follow the philosophy of value investing, which would shield them from substantial valuation errors and teach them to develop long term strategies. About ten years ago, my friend Magnus Caspar gave me a copy of this book and its lessons holds just as well today, as it did in past decades.
Although value investing has taken many forms since its inception, it generally involves buying securities that appear under priced by some form of fundamental analysis. In brief, it means avoid to buy shares in companies that are hyped or trendy or that looks good through technical analysis, and focus on buying assets that look good by the real numbers.
Such securities may be stock in public companies that trade at discounts to book value, have high dividend yields, have low price-to-earning multiples or have low price-to-book ratios. Simple. Anyone with a bachelor degree in accounting can easily identify such companies on public stock markets. In the table below from The Economist we can see Berkshire Hathaway´s biggest controlling holdings in 2013.
How come then that investors overall do not follow Benjamin Grahams teachings and Warren Buffett´s example? One reason is people´s short term thinking today. In general, we do not have patience. We want it all and we want it now, is the catch phrase of ambitious people. Value investing means to buy assets and gradually see them increase in value over years and decades.
The Investment Vehicle
In 1967 Buffett officially made Berkshire Hathaway a conglomerate, using textile proceeds to purchase National Indemnity, the first of what would be the many insurance companies that provided Berkshire Hathaway’s cashflow and enabled it to continue acquiring.
Berkshire Hathaway has over the years consistently given its shareholders better return than most other investments. As can be seen in the graph below, showing the value of USD 100 invested in Berkshire Hathaway in 1976, compared with the value of the same USD 100 invested in the Standard C& Poor 500 index.
Academic studies of Berkshire Hathaway confirm that Mr Buffett does what he says he does. Berkshire Hathaway has beaten the market over the long run by investing in relatively low-risk stocks the market was under-pricing, according to “Buffett’s Alpha”, a study by three economists at Yale, Andrea Frazzini, David Kabiller and Lasse Pedersen.
The study found that when it comes to outperforming the market on a sustained basis, Berkshire Hathaway is arguably without equal. The company’s Sharpe ratio, a measure of return per unit of risk, is at 0.76 higher than that of any other share or mutual fund that has traded for a period of at least 30 years since 1926.
The study also says that decomposing Berkshires’ portfolio into ownership in publicly traded stocks versus wholly-owned private companies, the researchers found that the former performs the best, suggesting that Buffett’s returns are more due to competent stock selection and holding than to Buffett´s effect on management.
What is the secret of Buffett´s unique success story? It is not all that complicated. There are mainly three lessons to be learned.
1) Long Term Focus
Warren Buffett has said that his favourite holding period for an investment is to buy and hold forever. Living up to his words, a number of his positions have been in the Berkshire Hathaway portfolio for years and even decades, and as those holdings increase in value, so does Berkshire Hathaway.
Buffett once said, “I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.” By focusing on the long term, short term hurdles, recessions and economic crises becomes less important, including the recent great recession.
In 2008 while many were fleeing the markets, Buffett wrote an opinion piece in the New York Times titled, “Buy American. I Am.” He started the text by saying: “The financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary. So … I’ve been buying American stocks.” He can say so with confidence, as he buys for the long term.
Through his investments and subsidiaries, Buffett has expanded his reach into numerous investments in the global marketplace. By diversifying into sectors including health care, industry, finance and consumer goods, Berkshire Hathaway has been able to weather sector based market turmoils and profit in times of strength.
With the Capital Asset Pricing Model (CAPM) and following investment theories, students of financial economics, such as myself, have been told that we should buy companies that focus on an industry or field that can be understood and mastered by the corporate management, and following such ideas Berkshire Hathaway can be seen as a pariah. However by looking at the company as an investment vehicle or very long term investment fund, that consistently invests and holds following value investment principles, the company´s diversified holdings does make sense.
To judge book values of a company over a long time to see the quality of the company and its performance has nothing to do with what the company really does and which industry it is in. The numbers do not lie. Warren Buffett and his team are experts on evaluating real numbers, disregarding short term marketing fads and hype.
Berkshire Hathaway pays no dividend. However, yield-bearing companies still represent a majority of the holdings in Buffett’s portfolio. Aside from being leaders in their respective fields, Buffett´s positions, including giants like IBM, American Express, Coca-Cola, Proctor & Gamble and Johnson & Johnson, are notable dividend payers.
One of the primary lessons by Buffett’s mentor, Benjamin Graham, is that dividends are an investor’s secret weapon. Many of the Fortune 500 companies that Berkshire Hathaway has large positions in have a steady history of maintaining or increasing dividends every year, and this is one reason Berkshire Hathaway has chosen to invest in them. Coca Cola has increased its annual dividend 52 years in a row.
The accumulated dividends paid to Berkshire Hathaway is then used to make new acquisitions. The money for this comes from real dividend cash flow. Not from profit of selling previously held stock.
However, the the bigger Berkshire Hathaway gets, the bigger the deals it needs to make to keep growing. Buffett touches upon this in this years “ annual letter”, where he writes: “Eventually – probably between ten and twenty years from now – Berkshire’s earnings and capital resources will reach a level that will not allow management to intelligently reinvest all of the company’s earnings. At that time our directors will need to determine whether the best method to distribute the excess earnings is through dividends, share repurchases or both. If Berkshire shares are selling below intrinsic business value, massive repurchases will almost certainly be the best choice. You can be comfortable that your directors will make the right decision.”
The Annual Letter
Warren Buffett writes an extensive annual letter to Berkshire Hathaway’s shareholders, each year, published a couple of months before the annual shareholder meeting. I started reading the letters from 1989 when I studied finance in business school. The letters are usually very well written and funny and below are some highlights from this years letter:
A truism on cash:
“At a healthy business, cash is sometimes thought of as something to be minimized – as an unproductive asset that acts as a drag on such markers as return on equity. Cash, though, is to a business as oxygen is to an individual: never thought about when it is present, the only thing in mind when it is absent.”
On the possibility of Berkshire paying a dividend:
“Eventually – probably between ten and twenty years from now – Berkshire’s earnings and capital resources will reach a level that will not allow management to intelligently reinvest all of the company’s earnings. At that time our directors will need to determine whether the best method to distribute the excess earnings is through dividends, share repurchases or both. If Berkshire shares are selling below intrinsic business value, massive repurchases will almost certainly be the best choice. You can be comfortable that your directors will make the right decision.”
On mergers and spin-offs:
“Investment bankers, being paid as they are for action, constantly urge acquirers to pay 20% to 50% premiums over market price for publicly-held businesses. The bankers tell the buyer that the premium is justified for “control value” and for the wonderful things that are going to happen once the acquirer’s CEO takes charge. (What acquisition-hungry manager will challenge that assertion?) A few years later, bankers – bearing straight faces – again appear and just as earnestly urge spinning off the earlier acquisition in order to “unlock shareholder value.” Spin-offs, of course, strip the owning company of its purported “control value” without any compensating payment. The bankers explain that the spun-off company will flourish because its management will be more entrepreneurial, having been freed from the smothering bureaucracy of the parent company. (So much for that talented CEO we met earlier.)”
This year it is 50 years since Warren Buffett bought Berkshire Hathaway, and therefore the letters contains a description of the 50-year history on page 23, “Berkshire – Past, Present and Future.” It is fascinating even if you never read annual reports and know nothing about the company.
Below is a video from Wall Street Journal with highlights of the 2015 Berkshire Hathaway shareholder meeting in Omaha, Nebraska, that took place last week. The devoted, about 40,000 of them, came out in full force to celebrate, meet other investors and do some shopping, as portfolio companies have stands to sell their goods at the annual event.
According to Wall Street Journal, the doors opened at 7 a.m. with shareholders rushing in to grab seats, save chairs for their friends and browse an exhibit hall with booths from Berkshire-owned companies. Attendees eating ice cream, shopping and chatting with one another before Mr. Buffett and his even older deputy Mr. Charlie Munger took the stage.