Friday 5: Five Lessons on Investing from Warren Buffett and Charlie Munger
My favorite lessons on investing from Berkshire Hathaway's shareholder letters. All taken from "The Essays of Warren Buffett" by Lawrence Cunninghuman.
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Warren Buffett and Charlie Munger’s track record.
#1: Seek to invest in businesses with excellent economics, able and honest management, at sensible prices. That’s the magic formula.
#2: Don’t be afraid to let a few investments grow to represent a large portion of your portfolio. That’s inevitable if you do well.
#3: Invest in companies you expect to be as competitive 20 years from now. The best investments compound over decades.
#4: Forgot the growth versus value debate—they’re two sides of one coin. Look for durable value and profitable growth in companies.
#5: Make Mr. Market your ally. Take advantage of his perpetual swings from euphoria to panic.
Read the full summary and buy the book.
Warren Buffett and Charlie Munger’s track record.
For those asking, "Why is it worth studying Warren Buffett and Charlie Munger's shareholder letters?" The answer lies in what Berkshire Hathaway has built over the last 50+ years.
In the introduction of The Essays of Warren Buffett, Lawrence Cunningham lays out the size and scale of Berkshire Hathaway’s operations and investments in just a few short paragraphs. It’s a staggering description given Berkshire Hathaway was built in just a few decades from the ashes of a failing textile business.
Buffett took the helm of Berkshire in 1965, when its book value per share was $19.46 and its intrinsic value per share far lower. Today, its book value per share exceeds $200,000 and its intrinsic value far higher. The growth rate in book value per share during that period is about 19% compounded annually.
Berkshire is now a holding company engaged in 80 distinct business lines. Berkshire's most important business is insurance, carried on through various companies including its 100% owned subsidiary, GEICO Corporation, among the largest auto insurers in the United States, and General Re Corporation, one of the largest reinsurers in the world. In 2010, Berkshire acquired Burlington Northern Santa Fe Railway Company, among the largest railroads in North America, and has long owned and operated large energy companies.
Some Berkshire subsidiaries are massive: 10 would be included in the Fortune 500 if they were stand-alone companies. Its other interests are so vast that, as Buffett writes: "when you are looking at Berkshire, you are looking across corporate America."
Buffett and Berkshire Vice Chairman Charlie Munger built this sprawling enterprise by investing in businesses with excellent economic characteristics and run by outstanding managers. While they prefer negotiated acquisitions of 100% of such a business at a fair price, they take a double-barreled approach of buying on the open market less than 100% of some businesses when they can do so at a pro-rata price well below what it would take to buy 100%.
By “on the open market,” Lawrence Cunningham means the stock market. A significant component of the magic behind Berkshire Hathaway’s success over the last 50 years has been the double-compounding of their acquired businesses alongside their portfolios of publicly traded companies. That strategy revolves around a single, profound insight: “Eventually, our economic fate will be determined by the economic fate of the businesses we own—regardless of whether our ownership is partial or total.”
The only thing that matters is that you buy quality, well run businesses affordably. And that you remove as many frictional costs as possible by embracing inactivity and holding for long periods of time.
Below are the 5 lessons pulled from Berkshire Hathaway’s shareholder letters about Warren Buffett’s and Charlie Munger’s investment philosophy.
#1: Seek to invest in businesses with excellent economics, able and honest management, at sensible prices. That’s the magic formula.
At the core of their philosophy is a simple, profound truth: That wonderful businesses with excellent economics and great management are rare. Extremely rare.
Which is why they work so hard to find just a few of these in their lifetime, acquire them in whole or in part at reasonable prices, and then hold them—come hell or high water—for decades.
Inactivity strikes us as intelligent behavior. Neither we nor most business managers would dream of feverishly trading high-profitable subsidiaries because a small move in the Federal Reserve’s discount rate was predicted or because some Wall Street pundit had reversed his views on the market. Why, then, should we behave differently with our minority positions in wonderful businesses?
The art of investing in public companies successfully is little different from the art of successfully acquiring subsidiaries. In each case you simple want to acquire, as a sensible price, a business with excellent economics and able, honest management. Thereafter, you need only monitor these qualities are being preserved.
While the hard work is finding these businesses, once you find them “you need only monitor that these qualities are being preserved.” Your goal is to be a long-term owner of an incredible business.
#2: Don’t be afraid to let a few investments grow to represent a large portion of your portfolio. That’s inevitable if you do well.
If you do this well, a handful of investments you make will grow to represent a very large portion of your portfolio. Henry Singleton and Charlie Munger are well-known for letting their highest conviction investment grow to represent 60%+ of their portfolio. That’s a fantastic outcome, not a situation to be avoided.
When carried out capably, an investment strategy of that type will often result in its practitioner owning a few securities that will come to represent a very large portion of their portfolio. This investor would get a similar result if he followed a policy of purchasing an interest in, say 20% of the future earnings of a number of outstanding college basketball stars. A handful of those would go on to achieve NBA stardom, and the investor’s take from them would soon dominate his royalty stream. To suggest that this investors should sell off portions of his most successful investments simply because they have come to dominate his portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team.
I really like this analogy of “cutting the flowers and watering the weeds” from Peter Lynch, which is cited in the 1988 Shareholder Letter:
When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever. We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hand on to businesses that disappoint. Peter Lynch aptly likes such behavior to “cutting the flowers and watering the weeds.”
Your favorite holding period should be forever. To do that well, don’t cut the flowers to water the weeds. Hold onto those flowers instead.
#3: Invest in companies you expect to be as competitive 20 years from now. The best investments compound over decades.
To find wonderful businesses that you can hold forever, you have to be incredibly durability focused. You have to find companies in a dominant competitive position with the ability to compete and win in their spaces for decades.
In studying the investments we have made in both subsidiary companies and common stocks, you will see that we favor businesses and industries unlikely to experience major change. The reason for that is simple: Making either type of purchase (majority acquisition or minor publicly traded position), we are searching for that we believe are virtually certain to possess enormous competitive strength 10 or 20 years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek.
I should emphasize that, as citizens, Charlie and I welcome change: Fresh ideas, new products, innovative processes, and the like cause our country’s standard of living to rise, and that’s clearly good. As investors, however, our reaction to a fermenting industry is much like our attitude toward space explorations: We applaud the endeavor but prefer to skip the ride.
While I’m not sure you want to avoid all fast-changing industries, you certainly want to avoid industries with perfect competition where achieving and sustaining a competitive advantage is difficult or nearly impossible.
#4: Forgot the growth versus value debate—they’re two sides of one coin. Look for durable value and profitable growth in companies.
While Warren Buffett and Charlie Munger are typically thought of as “value investors,” they’re focused on acquiring great businesses at fair prices. What matters most to them is the total value of the business both today and decades into the future. With that orientation, they look for both value and growth in every investment that they make.
As they share in the 1992 Shareholder Letter, both value and growth are important components in great investments. They care more about what they’re getting in terms of value than what they’re paying; and only like growth when it’s profitable growth.
Our equity-investing strategy remains little changed from what it was when we said in the 1977 annual report: “We select 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.” ✂️
But how, you will ask, does one decide what’s “attractive”? In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition: “value” and “growth.” Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.
We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component of the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.
In addition, we think the very term “value investing” is redundant. What is “investing” if not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value—in the hope that it can soon be sold for a still-higher price—should be labeled speculation (which is neither illegal, immoral, nor—in our view—financially fattening. ✂️
Similarly, business growth, per se, tells us little about value. It’s true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. ✂️
Growth benefits investors only when the business in point can invest at incremental returns that are enticing—in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of low-return businesses requiring incremental funds, growth hurts the investor.
#5: Make Mr. Market your ally. Take advantage of his perpetual swings from euphoria to panic.
If you do all of the above well, the final trick is learning how to take advantage of the market’s wild swings from euphoria to panic. It’s making the market your ally, so you can be fearful when others are greedy and greedy when others are fearful.
Think of this skill like a multiplier on your investment returns over your lifetime. If you can find and hold onto great businesses, and you can snap up shares when the market is panicked, you will do incredibly well over time.
The best analogy of the market’s swings is “Mr. Market” from Ben Graham. Warren Buffett sums up Mr. Market perfectly in the 1987 Shareholder Letter:
Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.
Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these conditions he will name a very low price, since he is terrified that you will unload your interest on him.
Mr. Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.
But, like Cinderella at the ball, you must heed one warning or everything will turn to pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful.
Read the full summary and buy the book.
All of these quotes and stories are from of The Essays of Warren Buffett. What Lawrence Cunningham has created with this book is remarkable. I'd argue that reading it in its entirety is more valuable than getting an MBA. If you want to study Warren Buffett and Charlie Munger, there’s no better way than by reading this book.
Read my full book summary for The Essays of Warren Buffett →
Until next week,
Daniel Scrivner
Coach to Founders & Design Leaders
Founder of Ligature: The Design VC