It’s that time of the year when Warren Buffet comes out with the widely read letter to Berkshire Hathaway’s shareholders. As always, it not only talks about the company’s performance but is a great source of investment wisdom. My aim through this post is to highlight some of key lessons which can act as source of inspiration for the Indian investors.
Important parameters to evaluate acquisition decisions (or before picking any stock)
- Durable competitive strengths
- Able and high-grade management
- Good returns on net tangible assets required to operate business
- opportunities for internal growth at attractive returns
- And most important, SENSIBLE PURCHASE PRICE
It always astonishes me how he manages to explain complex topics such M&A decision-making without going into financial jargon. Also, very interesting explanation of the ingrained thrust of CEOs for acquisitions (never misses to fit-in awkward sex jokes):
“Why the purchasing frenzy? In part, it’s because the CEO job self-selects for “can-do” types. If Wall Street analysts or board members urge that brand of CEO to consider possible acquisitions, it’s a bit like telling your ripening teenager to be sure to have a normal sex life.
Once a CEO hungers for a deal, he or she will never lack for forecasts that justify the purchase. Subordinates will be cheering, envisioning enlarged domains and the compensation levels that typically increase with corporate size. Investment bankers, smelling huge fees, will be applauding as well. (Don’t ask the barber whether you need a haircut.) If the historical performance of the target falls short of validating its acquisition, large “synergies” will be forecast. Spreadsheets never disappoint.”
How insurance companies make money?
He goes on to explain how he entered property/casualty insurance business by acquiring National Indemnity (along with small sister company) for $8.6 million, through which he got hold of $6.7 million of tangible net worth which could be directly deployed in the marketable securities (his domain of expertise).
Now the $1.9 million premium paid over the net worth was for:
- Underwriting profits
- $19.4 million of “float” – money that belonged to others but was held by our two insurers.
Characteristics/advantages of float:
- Premiums paid upfront to company whereas losses occur over the life of the policy, usually a six-month or one-year period
- Losses may take many years to surface and even longer to evaluate and settle
- Loss payments are sometimes spread over decade
- Grows as premium grows
- Certain P/C business (medical malpractice, product liability, etc.) generate far more float than others (auto collision, home owner policies, etc.)
- Unlike bank deposits or life insurance policies containing surrender options, p/c float can’t be withdrawn.
This information can come-in handy with the increased activity in Indian insurance space (couple of IPOs lined-up and also private players entering the foray). Don’t want to offer any particular stock tips but people are smart.
Performance comes, performance goes. Fees never falter.
A 10-year bet was made on 19 Dec 2007 that a virtually cost-free investment in an unmanaged S&P 500 index fund – would, over time, deliver better results than those achieved by most investment professionals, however well-regarded and incentivized those “helpers”.
2 Parties involved: Warren Buffet and Protégé Partners (picked 5 “funds of funds”). Those five funds-of-funds in turn owned interests in more than 200 hedge funds.
Though today, the earnings of the fund managers is linked to the fund’s performance but they always earn a component called “management fees”. Don’t underestimate this component!
“Those performance incentives, it should be emphasized, were frosting on a huge and tasty cake: Even if the funds lost money for their investors during the decade, their managers could grow very rich. That would occur because fixed fees averaging a staggering 2.5% of assets or so were paid every year by the fund-of-funds’ investors, with part of these fees going to the managers at the five funds-of-funds and the balance going to the 200-plus managers of the underlying hedge funds…
While this group prospered, however, many of their investors experienced a lost decade.
Performance comes, performance goes. Fees never falter.”
Bonds are risky than sensible stocks in long-term given you tweak the definition of “RISK”
Originally, Protégé and Buffet each funded portion of the ultimate $1 million prize of the 10-year bet discussed earlier by purchasing $500,000 face amount of zero-coupon U.S. Treasury bonds, which would deliver $1,000,000 in ten years. By late 2012 however, these bonds had a paltry annual yield-to-maturity of 0.88%. So, Berkshire and Protégé sold the bonds and purchased Berkshire Hathaway stock. This proved to be a wise decision. Instead of the $1 million that the bet would deliver to Girls Inc. of Omaha, they instead received $2.22 million
“Investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date. “Risk” is the possibility that this objective won’t be attained.
By that standard, purportedly “risk-free” long-term bonds in 2012 were a far riskier investment than a long- term investment in common stocks. At that time, even a 1% annual rate of inflation between 2012 and 2017 would have decreased the purchasing-power of the government bond that Protégé and I sold.
I want to quickly acknowledge that in any upcoming day, week or even year, stocks will be riskier – far riskier – than short-term U.S. bonds. As an investor’s investment horizon lengthens, however, a diversified portfolio of U.S. equities becomes progressively less risky than bonds, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates.
It is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments and savings-minded individuals – to measure their investment “risk” by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk.”
Thus, if the definition of “risk” is that you won’t achieve your pre-defined target of investment than bonds might become riskier than stocks in long term. In India, where inflation plays a crucial role, always try to calculate real returns (after taking inflation into account) as it can be a real eye-opener. Even your annual pay hikes!
Golden words on Long-term investment (applicable everywhere from USA to India to even Somalia)
“Charlie and I view the marketable common stocks that Berkshire owns as interests in businesses, not as ticker symbols to be bought or sold based on their “chart” patterns, the “target” prices of analysts or the opinions of media pundits….
For decades, we have stated in Principle 6 of our “Owner-Related Business Principles” that we expect undistributed earnings of our investees to deliver us at least equivalent earnings by way of subsequent capital gains. I feel confident, however, that the earnings retained by our investees will over time, and with our investees viewed as a group, translate into commensurate capital gains for Berkshire. The connection of value-building to retained earnings that I’ve just described will be impossible to detect in the short term. Stocks surge and swoon, seemingly untethered to any year-to-year buildup in their underlying value.
Over time, however, Ben Graham’s oft-quoted maxim proves true: “In the short run, the market is a voting machine; in the long run, however, it becomes a weighing machine.”
Just 3 words: Don’t trade, invest!
Why you should never borrow money to own stocks
“I can muster against ever using borrowed money to own stocks. There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions.”
As Keynes said, “market can remain irrational longer than you can remain solvent”
Another thing to note is he is ready to take a hit on returns but not to deter from investing principles
“Our aversion to leverage has dampened our returns over the years. But Charlie and I sleep well. Both of us believe it is insane to risk what you have and need in order to obtain what you don’t need.”
Successor Planning (at which Indian firms somehow fails)
If you looking to hold a stock for longer term (say 10 years), then always pay attention at the “AGE” of the key management professionals. If they are going to retire in coming years, then are they talking about the succession planning on the public forums? If not, tread cautiously as what may come naturally to them (as they have built and operated the businesses for so many years) may be a herculean task for the next person. Leave aside understanding the nitty-gritty of the operations, understanding the DNA and culture itself takes years (applicable for outsiders). We all now the issues we had at Infosys and Tata (though Chandra doing a fab job now!).
Plans are to split Berkshire split into two – investment management and operations. Berkshire has hired two investment managers – Todd Combs and Ted Weschler – who are each investing $7 billion on behalf of Berkshire.
“Each, independently of me, manages more than $12 billion; I usually learn about decisions they have made by looking at monthly portfolio summaries”
This sort-of commentary is very encouraging to read as an investor and which you will rarely come across in Indian equity space.
A Look at Berkshire Hathaway’s stock investments:
Kraft Heinz not included as Berkshire is part of control group
What caught my attention is the affinity towards firms belonging to Financial Services sector.
At 2017 year-end Berkshire held $116.0 billion in cash and U.S. Treasury Bills (whose average maturity was 88 days), up from $86.4 billion at year-end 2016. (Trivia: Apple holds $268.9 billion in cash and cash equivalents).
Just one closing remark: Never miss to read to watch Warren Buffet and Charlie Munger have to offer. Their investment philosophies can not only be applied to “Investment decisions” but also to other “Important Life-related decisions”
Click here for the letter.